Join our guests Tim Smith & Steven Frank as they share their insights in how the COVID environment is shaping value drivers for the technology industry.
[00:00:09] JL: Welcome to today's edition of DHG’s GrowthCast. I'm your host, John Locke. At DHG, our strength lies in our technical knowledge, our industry intelligence, and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG's GrowthCast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace. Thanks for joining us as we discuss tomorrow's needs today.
[00:00:42] ANNOUNCER: The views and concepts expressed by today's panelists are their own and not those of Dixon Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.
[00:00:57] JL: Our guests today are Steven Frank and Tim Smith, DHG’s technology industry group leaders. Tim serves as valuation principal in DHG’s Atlanta office. His professional background spans over two decades to include executive level leadership positions, both in the US and in Europe.
Steven Frank is a partner in transaction advisory services and works out of DHG’s Charlotte office. Steven has more than 17 years of public accounting experience, including 14+ years of transaction advisory services experience.
Great to have you both with us today.
[00:01:31] TS: Thanks, John. I’m happy to be here to talk a little bit about technology and what our clients are seeing and talking to us about, and share it with our friends outside.
[00:01:40a] JL: Great. Well, let's start with Steven. What are you hearing, Steven, from your tech software clients regarding the current environment?
[00:01:50] SF: Thanks, John. I think it’s in [inaudible 00:01:52]. I think early on with our work-from-home model and the shelter-in-place model, our tech clients are generally doing very well. I think they were well-positioned for the transition. I think a lot of them are servicing the industry staples, the industries that are really in need, grocery stores, hardware, emergency services, etc. I think technology is definitely needed in the current environment [inaudible 00:02:16] security services, etc. I think our clients are doing well, and they are positioned to transition from a work-from-home model very well.
Anybody with the recurring revenue seems to be strong. I mean, I kind of think a little bit more about private equity clients that are serving the technology space. For them, the change was really to focus more on the existing portfolio companies, helping them manage the current environment versus looking for new investments. But, again, I think early on they were very strong. I’ll say the last few weeks, maybe there’s a little bit more softness. I think some of the smaller businesses have more treasure to risk. Industries that are serving the non – Our technology clients, they’re serving non-essential industries that have been shut down such as restaurants, entertainment, gyms. I think there’s [inaudible00:03:07] bit more of the pain now.
I think in the short-term, those of types of models of business, the consumer models are more vulnerable while the business-to-business models talk about those as [inaudible 00:03:18] revenues who may be very resilient.
[00:03:22] TS: I would add to that that clearly the tech sector has a different sort of professional. The transition to work from home for those professionals was probably easier than the age-old accountants that are sitting on this call and thinking about, “Oh, my gosh! How do I use videoconferencing and things like that,” because that was sort of outside of our comfort zone. Then deeper than that, the clients I've spoken with have been – You drill it down to the sectors that they are actually providing services for and the method of delivery. What I mean by that is that some of them, they get an annual subscription fee rather than transaction fees for their software usage. If you have an annual subscription fee, then you’re not going to see any attrition at this point because we’re very, very early on into what's going on in the economy.
Those clients that we see that are on a transactional basis, they’re a little bit more sensitive to what's going on as the economy has slowed down. What I mean by that is that let's take a point-of-sale transaction processing company and its software for point-of-sale. Those point-of-sale revenues from Whole Foods or Home Depot are really, really killing it, but those point-of-sale for a gym or a movie theater or a restaurant, they had already seen the decline in their revenues. So it’s really about drilling down into the tech companies’ actual clients and how they bring revenue and bring dollars into their firms, and that’s where we've seen a divergence of ways that companies have done well and ways that our companies are struggling with with this new – The way the economy is working right now or not working right.
[00:05:31] JL: Yeah. A lot of it is tied to their industry segment. Like you said, some retail is killing it.
[00:05:39] TS: Agreed. You think about retail, grocers and Walmarts and big boxes of the world that have a bunch of different types of products are doing really well. But nonessential retail is having a lot of problems right now, and that's going to go across all of their – It’s going to be a problem for all of their vendors.
[00:06:01] JL: Steven, tell us what you think about the current environment and how does that play into value drivers.
[00:06:07] SF: Yeah. Good question, John. I think part of what we’re seeing there with the valuation [inaudible 00:06:13] is we have seen that starting to dip. While some of our clients are doing well or at least managing from a valuation perspective in an M&A space, we are seeing multiples coming down. I think early in March before COVID-19 hit, we saw revenue multiples at anywhere from five to six, six and a half times revenue. By end of March, early April, it was down to 4 to 4.2 times, so definitely valuations have been impacted.
But some of the key factor is value drivers. Recurring revenue is still king. I mean, there’s a mix of clean high-subscription models versus lower subscription. Definitely, it’s driving value. Investors are sitting on higher quality customer bases that, back to my comments earlier, we’re starting to see some risk in exposure to small businesses. Again, it’s not just looking at the targets revenue. It’s looking at that revenue being generated from, so [inaudible 00:07:17] higher quality customer base is more attractive to our clients. It’s probably making the clients investors.
I think they’re heavily focused on pipeline mix as well. What percentage of the revenue is derived from expansion and those upsells into existing customers as opposed to potential revenues coming from new customers? I think I – [inaudible 00:07:37] clients are finding that some of their own portfolio companies as well as to target some [inaudible 00:07:42]. They’re finding it easier to sell through to existing customers and going out and finding new customers.
[00:07:52] TS: That is so true, because right now sales forces are grounded. Trying to bring in a new client is immeasurably harder, so the idea of what is your pipeline for growth and having that focused, as Steven said, on retention, upsales, renewals. Those are all critical pieces to actually retaining value right now. I say retaining rather than growing, because we’re in a sort of a weird spot with the way valuations are hitting right now, and there's going to be a opening up of the companies that are able to grow value from here and those that are going to not be able to sustain that sort of value growth because they're not doing – Or they’re in the wrong industry. They’re serving the wrong industry or they’re doing some of the wrong things.
It may be masked over time, especially for those software companies that get annual license fees. They may not see this until six, nine months from now if they just all re-opt in January, and so that could be a big area where are our tech clients are going to have to pay attention to any sort of data they get from usage of their software so that they understand. Well, if our software usage is going down come next January 2021, we may be in for a hit on revenue because XYZ customer thinks they’re not using the software as much, and they’re going to want to bring fees down.
This is the time to be a little bit more diligent around what's happening in the current customer base, not just in terms of retention but in terms of usage and other statistics that could be used to tense them when it comes time to renew in a few months or in eight months, nine months, whenever the time comes around.
[00:09:48] JL: Yeah, and so the valuation has got two major components, the current maintenance of clients to maintain that valuation and then the growth of the business. How do you grow a business in this environment, Tim?
[00:10:07] TS: I like how you open that up with value and what drives value because in the tech software, especially in the software as a service world, there is such an emphasis on profitability and growth. One of the rule of 40 where the growth rate and the profitability margin added together should come out to 40 is just a nice little handle that we use when we’re thinking about whether a company is going to be more or less valued by the markets, and those two items do correlate very well with revenue multiples when we look at that over time and across different companies in the tech sector.
In order to continue to push growth forward, there has got to be a focus on current customers and, as Steven said, on upsells and renewals since the sales force is grounded. The sales cycle for new customers is definitely lengthened with the sales force grounded and just with the fact that all these customers of these tech firms are dealing with exogenous issues that they have, and so they’re not going to be as focused on bringing in the software from our tech clients like they were before when they didn't have as many things you have taking up to their mind space. The quality of sales pipeline is critical, and value is going to be based upon how much growth they can continues to sustain.
Like I said, the contrary growth is when clients are going to have contraction and – I mean, tech companies, our clients, are going to have contraction in their clients in terms of revenue. Being very mindful of the store and the attrition rate, not just at a customer level but at a leaking revenue level for each of your clients is going to be crucial to maintaining some level of growth through this downturn that we’re going to have in the economy as things continue to move forward.
The other piece of a tech company's innovation, and this is really sort of fuzzy, and so it's hard for us accountants and valuation folks to talk about it. But innovation is critical to the tech sector and how will they continue to innovate in a work-from-home structure is to be seen. Really, you’re going to – The best companies will continue to innovate and they’ll continue to do that from a work-from-home environment and drive value.
Then the other piece that besides growth and probability is capital availability and having the access to the capital the company needs to continue on that growth phase, because a lot of these companies, they really – They have more growth in that rule of 40 than they have profitability, and therefore they need outside capital to continue to push things forward and to continue to bring in new clients. From that perspective, you see problems because, as Steven said, private equity is taking more time to get through diligence, and that goes not only in private equity but public companies that are buying other companies. Diligence is harder now, because we’re doing it in a work-from-home environment.
The other piece of this is that a lot of the tech companies out there and a lot of our DHG clients are small and medium businesses that did not have a big cash reserve to make it through this liquidity crunch that’s happening through the quarantine and then the following economic downturn. That’s going to be problematic, and there’s going to be shake out there as well. Steven, maybe you can talk a little bit more about sort of private equity and the process and things like that that are constraining capital availability for these companies.
[00:14:31] SF: Yeah, absolutely. I mean, that is a fact in valuation, especially in an M&A space. I mean, lending is becoming harder. Are the equity clients – I mean, they’re approaching the lenders. They’re willing to still provide financing, but lenders are starting to see higher yields and more structure [inaudible 00:14:49] or definitions. Yeah, our client’s, they’re willing to accept lower [inaudible 00:14:55] ratios. They’re still getting deals done. But as it’s becoming a much higher market, and I think we see clients that would strive to get four to five times leverage. [inaudible 00:15:07] two and three times. If you’re willing to accept [inaudible 00:15:11], deals are getting done but it’s just going to be tighter.
I think we’re seeing clients that have a little bit more flexible capital structure are the ones being more aggressive in the market right now and wants it – They’re still trying to get two and three deals done versus sitting in with sidelines waiting till things change. Again, it can happen. But to your point, Tim, that tightness in credit markets is really impacting the valuation, just getting deals done. The [inaudible 00:15:39] deals gone from diligence perspective. I mean, [inaudible 00:15:45] our process is work three to four weeks. We get in and get out. We [inaudible 00:15:50] the deal. But with the current what’s involved environment, deals are just taking longer.
I mean, targets are focused on trying to run their business, trying to manage working from home, so just the overall data flow for both giving data to our private equity clients as well as data that are taking longer. We got management meetings where we used to go on site and get through the management Q&A within a day, day and a half. Send it out to two or three days as we try to break up meetings into two and three-hour windows. It has become a [inaudible 00:16:23] not just from financial due diligence and tax due diligence but start to finish for our clients.
[00:16:30] JL: That’s great.
[00:16:31] TS: I think what that means is that if you have as a tech company a shortage of capital, you're going to have a pause on capital deployment, and so that goes back to the innovation discussion where if you're having a higher level or a higher hurdle to get over to deploy capital, you’re not going to innovate as quickly because you don't have as much opportunity serve in the hopper going on. That’s going to be a deductive value as well that’s not as calculatable as revenue growth or profitability. But it definitely will impact both of those because this is – Software and economy is a skill game. You need to get more and more clients to draw it more and more to the bottom line.
[00:17:27] JL: As we wrap up here today, Tim and Steven, for our listeners’ sake, what advice or encouragement could you give them? What would be one thing that you could give them to hang onto as we flow through this difficult time and begin our emergence into this new world? What would be one thing to focus on?
[00:17:47] TS: When I look at the situation for our clients and preserving value, I really think that those tech clients that are on annual subscription type of set-ups with revenue need to be very, very diligent around understanding how their ultimate clients are using software. I already said this but I think it's important because that revenue hit is going to come later, and anticipating that revenue hit and fixing the expenses before that revenue hit is going to be critical to survival, especially the small and medium tech businesses. That’s not only survival but clearly value maximization, because those who survive with what’s going on right now are going to have big opportunities to grow on the back end as we come out of the recession that’s ultimately going to happen from coronavirus.
[00:18:44] JL: Steven, what do you think?
[00:18:46] SF: Yeah. I think the paying off debt time. I mean, I would just like to leave a positive note and optimism. I think there’s – From an M&A perspective, there’s a lot of opportunity down the road. [inaudible 00:18:57] be another month from now or two months from now, but there’s other trillion dollars of dry powder [inaudible 00:19:02] world waiting to be deployed. Once the economies improve, the credit market’s starting to loosen, I think we’ll have a very strong and robust M&A market again.
[00:19:13] JL: I love leaving on a positive note. That’s something to look forward to for all of us, isn’t it?
[00:19:19] TS: Agreed.
[00:19:20] JL: Yeah. Well, thank you both for being here today.
End of Interview
[00:19:23] JL: You’ve been listening to the DHG GrowthCast with Tim Smith and Steven Frank, leaders of DHG’s technology group. We hope that you have gained additional insights on the value driver’s growth and capital challenges facing technology companies. I'm your host John Locke and I look forward to reconnecting with you again soon on an upcoming episode of DHG GrowthCast.