Death to Revenue Multiples: Long Live the DCF!
By Rick Zullo, GP & Co-Founder at Equal Ventures
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As long as I’ve been an investor, VCs have leaned on revenue multiples to justify valuations. These multiples have gone up and down over the years, but have been the cornerstone of setting valuations in the tech world. Unfortunately, these multiples have proven themselves to be useless in properly determining the true long-term value of businesses, and I think it’s high time to do away with them.
Revenue multiples were established as a proxy for future profitability multiples like EV/EBITDA, EV/FCF or P/E. The theory was that software companies (given their high gross margins) would eventually generate significant FCF at scale. This historically laid a fine foundation. There were significant barriers to entry for starting a software company (limiting competition), distribution networks and customer behavior were fairly entrenched and revenue patterns were fairly predictable. This led to companies seeing 20–40% FCF margins at scale, enabling investors (private AND public) to forecast out to that future period and discount those cash flows. The process for doing this has become the historical basis for valuation — Discounted Cash Flow (DCF) analysis. As time went on, revenue multiples became the proxy enabling investors to place a value based on a software company’s growth and revenue, rather than the far more detailed exercise of forecasting its future cash flow.
The second our industry took its eyes away from forecasting future cash flow, we should have been worried. As Munger said, “you show me the incentive, I’ll show you the outcome” and sure enough, once the means for valuation became around revenue multiples (and not the DCF), companies architected themselves around revenue growth, not future cash flow. Investors did the same in turn, believing that the companies would keep growing in valuation provided that revenue kept on growing and multiples maintained. Unfortunately, multiples didn’t hold up, largely because many of these companies were forced to experience the scrutiny of public markets, which have a much more keen eye for forecasting future cash flows and quickly realized that many of these companies had no window to future profitability in sight.
As we look at today’s environment, competition is accelerating at a pace unlike any we have ever seen. Advancements in enabling technology (Gen AI in particular) have made the barriers to entry for building a software product effectively zero and the entrenched distribution networks of past years have been traded for performance-driven ad exchanges and 3rd party marketplaces. There is an argument to be made that the persistence of revenue has never been weaker for the technology industry as a whole, however, there are incredible bright spots.
As a firm, we continue to see companies that are growing with immense captivity over their markets, strong network effects in their business and escape velocity growth. These companies have mitigated competition to develop the ability to generate incredibly efficient growth with a path forward to incredible FCF potential in the future. The process of strategy, goal setting and performance management has become far more nuanced, but it’s also become far more important. The growth-at-all-costs dynamic was built around the façade of revenue multiples, when the real pursuit should have been around developing competitive advantages in your business, monopolizing your market opportunity and generating long term free cash flow. We work endlessly with our founders to formulate their guiding star for creating value in the company and feel the results of doing so will significantly outperform those from chasing revenue multiples.
While no one wins “cool kid” points touting the marvel of a DCF model, the shorthand math of revenue multiples does a disservice to us all.
Death to revenue multiples, long live the DCF!
