A Structured Approach to Analyze Businesses in the Tech Sector

January 10, 2023

Analyzing businesses operating in the Tech sector is challenging because of two primary reasons: growth/upside potential and business risk. Rejecting a business case may result in losing out on lucrative return opportunities while investing in a Tech business may also expose the investor to business risk. Business risk implies operational failure to execute the business plan.

Traditionally, the buy-side industry has used tools such as Adjusted EBITDA, Annual Recurring Revenue (ARR), Customer Acquisition Cost (CAC), Customer Lifetime Value (CLV), Gross & Net Run Rate, and other financial/economic metrics to analyze and compare Tech companies. In my opinion, all these tools are relevant and important as they provide objectivity to the analysis. However, these tools provide limited visibility on the upside potential and business risk. In my opinion, the most important aspect to analyze a Tech business is the long-term Vision. Since Vision can be a vague term, let us assume that it is the “desired state” of the business in the next 5 years for our analysis.

Having a long term Vision in place helps the business to do the following:

Investing in the right tech stack allows the business to unlock the growth potential in the long term and minimize re-development expenditure
Developing the most suitable business strategy (including the marketing mix (4Ps), value proposition, target market, etc.) to achieve the long term Vision
Hiring the right people and developing the most optimum organizational design to execute the business strategy
Selecting the right KPI’s for performance evaluation and monitoring – without having long term Vision as an anchor point in business analysis, there is a risk of overemphasizing/underemphasizing on particular performance metrics/KPIs from a long term perspective
Preparing an action plan aiming to reach the desired state such that the resources, OPEX and CAPEX are aligned and realistic

Focusing on the Vision also helps to minimize the exposure to business risk in the investment process. Another argument of long-term Vision being the driving approach in business analysis in the Tech sector is driven by the structure of DCF or VC approaches to business valuation. Terminal value is the key determinant in the valuation (~60-80% in DCF and 100% in VC approach). Anchoring the long-term Vision would also help refine the terminal value by shortlisting the right comps and appropriate funding round (assuming the terminal value is based on exit multiple).

Under this approach, responses to the below questions (in order of priority) will drive the business analysis process from a buy-side perspective.

Do you believe in the business case for the desired state (Vision) of the organization? Will there be a market for the product/service this company is trying to develop? Will this product/service be competitive?
Is the desired state (Vision) achievable considering market fundamentals and regulations? Do the industry trends support the business case?
Does the action plan align with achieving the long-term Vision by breaking it down into short-term objectives starting from the current state of the business?
Does the OPEX and CAPEX align with the resource requirements of the action plan?
Does the business currently have the right resources (including management) to achieve required short-term and long-term objectives in the action plan? If not, is it reflected as an incremental OPEX or CAPEX?
Are you paying the right price for acquiring the business? Once the above questions have been considered in the DCF model, the output for valuation will closely reflect the fair value of the business.

Unarguably, there are several limitations to this Vision-based approach for business analysis. One can argue that the Tech sector is dynamic and businesses need to adapt to changing business environment. However, analysis of alternatives available, such as more traditional approaches of focusing on the existing business fundamentals, increases the two key risks (missed growth/upside and business risk) in the investment screening process.

Things to look out for:

A company with “Technologies” in its name doesn’t mean it is a Tech business. This can be a gimmick to get Tech industry multiples for valuation while the core business may be based on a different industry. The Vision (or the desired state in 5-years) will determine if this is a Tech business or not.
Business plans are nothing more than a piece of paper unless they are backed by solid assumptions, a strong management team, and alignment of stakeholder interests.
The action plan and implementation plan are critical in evaluating the progress towards the desired state (or the Vision). Without achieving short-term objectives, long-term goals cannot be achieved.
Do not forget to track the traditional KPIs along the way. ARR, CAC, CLV, etc. are all critical and say much about how the business is performing in the context of its business stage.
Lastly, do question the fundamentals of market size, market share, and other assumptions in the business case. A lot of good-quality material and publications have become outdated after COVID-19.

Hope you enjoyed reading. Please feel free to share your comments and suggestions.

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