Not everyone grows up to be a unicorn
In this article, based on a recent podcast (see bottom for details) I want to look a bit at unicorns. Specifically how some companies get to be unicorns, and how some don’t. One good starting point is looking at the sale prices that various technology companies have managed to achieve, and the characteristics of those companies.
In this case specifically I want to talk about IoT and the measure of revenue multiples. That being the ratio of sale price to the revenue a company made at the point when it was sold. It’s is a crude benchmark for any organisation’s valuation. It ignores intellectual property, debt, underlying strong or weak management, and demand-side drivers around how desperate the buyer might be for the assets, and many other things besides. However, it does point to a trend.
By doing this analysis of recent sales (there’s a chart below) one major trend leaps out: hardware vendors (except those making semiconductors) and connectivity companies are valued a lot less than software companies. When Sierra Wireless bought IoT MVNO Numerex in 2017 the multiple on revenue was approximately 1.5x. Numerex had quite a few problems, and a betting man would have said that was probably a low water mark for this particular part of the value chain sector. In comparison, when Kore Wireless acquired Raco in 2015 the comparable figure was around 3x revenue. So a range of 1.5-3x for connectivity providers.
For hardware vendors it was typically even lower. Often little more than 1x revenue, although Ericsson’s Cradlepoint acquisition last week was about 6x revenue. So a significant outlier.
In comparison, software companies can secure a valuation (or sale price) of 15-20 times revenue. This might seem to dictate that software is the route to great fortune.
This is not necessarily true. The multiples of revenue for the successful sales are much higher. However, what is ignored are the hundreds of software start-ups that never go anywhere. Part of the reason for low valuations on the hardware side of the house is that there is almost always some residual business left that has some intrinsic value even if it has long ago drifted away from profitability. Even bad hardware companies are worth something. That drags the average down. For software firms, that tends not to be the case. Bad software companies just disappear.
Survivorship bias is a massive challenge in the technology world. Those small fraction of software players who manage to hit a demand sweet spot, typically at just the time when a moneybags buyer identifies a gap in its portfolio, can command 10x+ multiples on revenue. Anyone looking at the market opportunity in IoT will tend to focus on that too. For module manufacturers, for instance, who can typically only command 1-2x revenue valuations, the idea of diversifying into the software platform space is clearly tempting. However, the chances of hitting the jackpot and coming up with (by build, borrow or buy) a winning formula in the software space are low.
As ever, recommendations to organisations to diversify outside of their core business area, usually at substantial cost, are only worthwhile if that vendor proves against the odds to be successful at it. Part of the challenge is that it’s not entirely unheard of. The real success story was Jasper which pivoted from MVNO to software platform company, but its overnight success took the best part of a decade. The multiple in that instance was almost 20x revenue. On the hardware side, Silver Spring Networks’ acquisition by Itron was based on a revenue multiple that was edging towards 3x. Despite being predominantly a hardware company it had also developed a strong management platform alongside. However, the analogy with latter-stage diversification is not a great one, as SilverSpring built the platform capabilities much more organically alongside the hardware/networking offering.
The software market has the lowest barriers to entry of any space, but nominally commands the highest multiples on sales. However, what this fails to take into account is the number of software players that have fallen by the wayside in the interim (as noted above). The average multiple is hard to calculate without an effective way of including shuttered start-ups. But safe to say that the 20x+ revenue multiple exits are the exception rather than the rule.
The other variable that needs to be considered is scalability. Software platforms are almost universally scalable, allowing the vendor to sell to every client with almost no incremental cost, other than the direct cost of sales. The manufacture of silicon chips is as close to scalable as the hardware space gets. Module manufacture and reselling of connectivity have been much more localised and less scalable. The least scalable function is that of consulting or systems integration. As a result, valuations of organisations performing such functions will necessarily be lower. However, all of this presupposes that valuation is the ultimate goal. Not every company can be a unicorn, and the space for potential unicorns is crowded. It was interesting to see hardware vendor Libelium decide to diversify not into software, but into consulting and implementation services. That’s where there is money to be made, and real client need.
Diversifying out of core business and into an adjacent part of the market is an overly simplistic solution to any organisations’ woes, particularly if all it is trying to do is boost its valuation. Diversifying to secure synergies is a far more defensible strategy. Having eyes on the unicorn prize means that most hardware and connectivity vendors will miss the fact that high value software exits are the exception rather than the rule.
I've clipped this article out of the transcript of the latest episode of my podcast 'The Wireless Noodle'. The episode is also called 'Not everyone grows up to be a unicorn'. Link to the podcast site is below, including links to access it and full transcript.