Driven by low interest rates and inflated valuations, the post pandemic tech industry boomed, with the strongest growth companies facing unprecedented choice and attracting an array of investors. However, 2022’s tech deep freeze reversed this momentum. Since November 2021 the market declined significantly.
In this guest post, Risana Zitha, managing director and head of Africa at DAI Magister, an investment bank advising international technology and climate companies, outlines how this downturn has changed the mindset of private equity investors, as capital efficiency, growth balanced by profitability and positive unit economics have all emerged as priorities for VCs in today’s market.
Today’s market is still adapting to a shift in profitability. Private equity investors who ‘dropped down’ to chase growth and lower valuations at earlier stages no longer see growth as a substitute for cash flows.
How growth companies should approach 2023
Strong growth companies have two options to consider – growth funding or private equity (PE) – and the criteria for both differ greatly. For higher valuations, growth-oriented investors and ‘like-minded’ sponsors willing to support ambitious plans are usually preferable, whereas many PE investors remain cautious by nature.
Here are the key areas companies should focus on to attract serious growth capital in the current market:
For companies to qualify as growth investments, investors need to see at least 50 per cent annual top line growth. Therefore, businesses must demonstrate clear potential for growth to persist in the medium term backed by a credible and actionable business plan. They should also be able to show a sufficient and addressable market, as well as the operational or product levers the company will use, to achieve future growth.
Most PE investors are happy to back professional managers, as the focus remains optimising business operations toward an exit. In contrast, growth investors need to see founder DNA, with senior figures displaying ambition to solve problems and scale across several markets. If a founder is both emotionally and financially invested in a company’s success having built it from the ground up, growth investors will feel more comfortable parting with their money.
Margins that expand in tandem with revenue growth lead to positive unit economics, where growth in a company’s revenue base creates operating leverage on its fixed cost base. Growth investors are increasingly attracted to a margins-focussed growth indicator, which is often in contract to an onus on EBITDA. Businesses with the potential to expand EBITDA and achieve operating leverage based on just cutting costs or optimising operations, are far more suited to private equity investors.
Rule of 40
Measuring potential by growth alone is insufficient: this should be balanced by profitability. The rule of 40, where the annual growth rate of the business plus its EBITDA margin exceeds 40 per cent, is a standard metric for profitability. This indicates balance between a company’s growth and existing cash needs. In today’s market, companies typically need to score 50+ with above 50 per cent growth rates (today or visible in the near future) to convert more cautious growth investors.
Capital and sales efficiency are top priorities once again come for growth investors, having carried little weight during the investment bubble of 2020 to 21. Sales efficiency is a ratio of sales spend to incremental ARR, which must be better than 1 ( minimum 0.75), which means $1 invested in sales should yield at least $1 of additional ARR. Where the ARR ‘yield’ is below 1, investors today view that company’s model as sales-inefficient.
Expanding product offerings, expanding metrics tracked (ARPU, basket size, conversion, etc) or broadening markets (functionally or geographically) are effective tactics companies can employ to elevate their positioning, which generally leads to a rise in valuation. For example, a leading player within payments for the retail market in a certain country can achieve a step change in valuation if it articulates a clear plan on how it will become the leading regional payments provider across several sectors. Doing so demonstrates a company’s ability to build a competitive advantage across multiple geographies, and indicates growth in its total addressable market from previously conceived.
Today, more than any time in the past three years, investors need to be able to visualise a credible exit path for their investment. Companies’ strategies must therefore be aligned with the proposed exit path for the business. Matching KPIs with those of the potential acquirers and demonstrating how they would fit strategically with the best buyers is essential for companies considering an exit.
Companies looking to exit via IPO must show how they will build momentum in the lead-up to the listing, and the steps they are already taking to become a resilient public company. However, IPOs are rarely the preferred path for a full exit for growth investors. Instead, they often remain involved for a long time after a listing, and their own fund returns get measured based on how well a company does months, or even years, after IPO.
Dollars earned during downturn more valuable
Organisations remain at the mercy of the current downturn, but the factors detailed above outline how they can adapt to deliver an exit strategy. When funds are scarce, capital becomes a strategic asset that companies can use to acquire customers, talent, or competitors. Therefore, businesses should recognise the heightened value of each extra dollar earned during a slump, in comparison to periods of boom. In an environment where everyone is struggling to raise capital, capital is a tactical requirement, and for many companies this more than justifies raising money at pre-2020 prices.
Successful fundraising efforts during market downturns are often rewarded with acquisitions or exits via IPO when the market rebounds, which strengthens the case for raising capital today to reap the benefits of the economy’s upswing. For companies following a sustainable and credible growth strategy, raising from growth investors is the most effective means of accelerating valuations, and options, coming out of the downturn.