Should You Trade off a Revenue or EBITDA Multiple?

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Before we begin, I need to talk to you about the talking Olaf in my home

The kids have (unfortunately) discovered the storage space in the attic, where we hide a giant talking Olaf statue thing. My kids are obsessed and have insisted I take him out and plug him into the wall, way ahead of his normal Christmas season duties.

My wife, a firm proponent of the Gregorian calendar, refuses to let him downstairs. Refuses. I'm talking Terry Tate Office Linebacker defense on Olaf.

So naturally, we compromised, and put him upstairs in the hallway right next to my office.

As such, he scares the living shit out of me twice a day. As I stumble between the Nespresso machine downstairs and my Lenovo, transporting my iced coffee, the motion detector sets him off and I'm unexpectedly greeted with extremely loud snowy encouragements.

A giant rubber blow up fictional Disney character is the closest thing I have to a real in office co worker.

Thought you'd enjoy that.

Speaking of mystical creatures… have you watched The Gentlemen on Netflix? That show is the bees knees.

Bobby Glass is an aging gangster who runs a massive cannabis empire in London from prison, a term I use lightly, as his camp cupcake setup has a sauna and private chef.

When faced with a tough decision in Season 2, he summons the Bannik, a mythical Slavic bathhouse spirit that communicates entirely through physical touch. If you ask it a question and get a soothing rub, you're in good shape. If you're violently scratched by its claws, things aren't looking so hot.

That's also how the valuation Gods decided if you trade at a Revenue vs EBITDA multiple.

• Revenue = soothing rub.

• EBITDA = bloody scratch.

In all seriousness though, how do you decide?

The origins of revenue multiples

It's a long standing Silicon Valley joke that you trade at a revenue multiple when you don't have profits.

Yes, there's some mathematical truth to that. A negative EBITDA multiple isn't particularly useful.

But the underlying belief is your company is growing so fast that your growth trajectory will completely swamp whatever your cost structure is today, making the lack of profits merely a point in time.

That's the hope with many of the AI companies right now. Investors are thinking there's no way these businesses will have to keep growing their cost bases as fast as their revenues (point in case: Anthropic grew Q2 revenue by 1,368% y/y while compute costs grew only 300%.). Operating leverage should kick in as they get to scale and realize better unit economics.

Revenue is a tidal wave that will drown costs.

I wanted to put some math behind this, so I took a $100M revenue company with a $150M cost base and flexed different growth rates over three, five, and ten years to see when it could get to breakeven.

Obviously, the answer depends on how quickly your costs grow alongside revenue. But the point is that when you're growing 30%, 50%, or 75% a year, today's losses can become pretty irrelevant to what the business looks like a few years from now.

Rough rule of thumb: You need to be growing 30%+ to get the really juicy revenue multiples.

Gokul Rajaram, investor at Marathon MP, explained the logic:

Another way to look at this is 15% growth takes five years to double. And waiting five years to double your revenue is a non starter for a market that pays for companies to violently pull the future forward.

At that point, investors have a much harder time ignoring today's P&L and giving you credit for some hypothetical future margin structure. In their minds, you're living in the present. And if you're living in the present, they want to know how much cash the business can actually produce.

Gokul put it another way:

Which is why one of the worst places to be is growing 20–30% with no profits. You're too slow for growth investors who want to pay for a massive future revenue base, and too unprofitable for investors who want to underwrite cash flows today.

Can profits ever hurt you?

Kind of. They can at least cloud the picture.

And that's the other Silicon Valley joke: you trade at an EBITDA multiple when you have profits.

It's a remix of the Russ Hanneman pre-revenue joke from the show Silicon Valley: you don't want profits, because then you have profitable expectations. Therefore, never become profitable!

This is kinda sorta true within a narrow range.

I was talking to Rick Smith, serial CFO, about this on the podcast. In his book, Six Months to the Sale, one of the more interesting ideas he covers is that sometimes it's actually bad to be just a little bit profitable.

For context, both Rick and I have mostly worked with venture-backed, high-growth software companies. So what I'm about to say isn't always going to be the case. If you're selling a distributor or a maintenance company, buyers are absolutely going to gravitate toward EBITDA. That's the cash-producing business they're buying.

But in our world, ARR growth rates and gross margin percentages can drive valuation more than current profit margins.

Especially when you're dealing with a strategic buyer.

If a strategic buyer is planning to fold your business into its existing operations, they're probably not planning to keep a whole lot of your Opex. They may not need your entire finance team, HR department, or even all of your sales and marketing organization. What they really want is your customer base, the recurring revenue that comes with it, and the ability to sell more products to those customers.

So they're going to focus on your ARR, really dig into the quality of your sales pipeline, and figure out what the business could look like under their ownership.

Your current EBITDA might be a pretty sucky representation of that.

Now imagine you're a growing software company that just flipped to being EBITDA positive. Congrats! You're profitable!

Unfortunately, you're profitable at a 3% margin.

You believe that at scale this could be a 30% EBITDA margin business, but you've now given the buyer an actual margin to anchor on. And it's a dumpy one.

Rick explained it this way:

I thought this was a pretty fascinating way to look at the tradeoff.

As a seller, you'd ideally either have negative EBITDA and a grounded viewpoint on what your ultimate margin structure could look like, or have tons of EBITDA already.

The awkward middle is where you're mixing two mediocre stories. You're asking the buyer to pay for your future earning potential while handing them a present-day profit margin that's nowhere near what you believe the business can eventually achieve.

And now the buyer has a number (and profitability story) to negotiate against.

Net net: If you have profits, great, you're profitable. But now we're going to also measure you on that profitability.

What if you are not growing fast and not profitable?

You're France, a sclerotic state.

(I'm kidding, I was in France literally two weeks ago and it's beautiful. Crème brûlée is dope.)

That's when the 1x and 2x revenue multiples come out to play.

And they don't really "come out" as much as they are just the math people do after a deal closes so they can put a multiple in the news headlines.

Think about the kind of situation where a once high-flying software company has slowed down, still burns cash, and has raised hundreds of millions of dollars at valuations that are no longer remotely supportable.

In a distressed transaction, there's a good chance the buyer isn't starting with a debate over whether the business deserves 1.8x or 2.1x revenue. They're underwriting what the asset is actually worth to them, how much cash they'll need to put into it, and what liabilities they're inheriting.

And on the other side of the negotiating table, the sellers may be more worried about what proceeds are left for shareholders after the liquidation preferences are satisfied.

There's no time to argue over the handle when you are just trying to clear the pref stack.

What's the best profile?

In the long term, a business is valued on its future free cash flows, discounted back to the present. You want to march toward the Elysium of 25%+ profit margins. At that level, you only need to grow 15% annually to be a Rule of 40 company.

Sounds somewhat reasonable!

But in the medium term, especially if there's a transaction coming up (M&A or fundraise), I'd be trying to push growth as high as reasonably possible while maintaining healthy gross margins.

And I emphasize gross margins because it's easy to juice revenue growth while giving away the farm on costs. If every additional dollar of revenue costs you 95 cents to deliver, I'm not super impressed by your growth rate.

Here's an example.

Say you've got two software businesses with similar recurring revenue quality, retention, gross margins, and market opportunities.

If you have the choice between transacting as a company with 33% revenue growth and -5% profit margins versus 23% revenue growth and +6% profit margins, I'd take the former ALL DAMN DAY.

And the funny thing is, Company B actually has the slightly better Rule of 40 score.

But at 33% growth, you're doubling your revenue base in a little over two years. At 23%, it's closer to three and a half. You're offering an investor a much faster path to scale, and potentially a much larger business to eventually harvest profits from.

Those extra ten points of growth can be worth considerably more than the eleven points of profitability you're giving up today, assuming the growth is durable and you're not destroying your unit economics to get there.

That's why I'd be careful about sacrificing meaningful growth just to squeak into positive EBITDA territory before a transaction. You might make the current-year P&L look nicer while making the overall business less attractive to the buyers who would otherwise pay the most for it.

The exact trade-off depends on the market and the buyer, but for high-growth software companies, incremental growth can command a much larger valuation premium than a few points of near-term profitability.

So remember: with small profits come great expectations.

Wishing you trade at a high revenue and EBITDA multiple,

CJ