The revenue behind the multiple

Two businesses can report the same revenue and offer a buyer very different futures. One may require substantial human effort to deliver every additional pound. Another may serve more customers through an established product. One may depend on a handful of relationships. Another may have a broad base that renews for fairly ordinary reasons.

The revenue line is a useful introduction. It is a rather brief description of a business to buy.

This becomes especially important when software and services sit together. A managed service may include excellent technology, while a software subscription may include a considerable amount of manual work. The labels are convenient. The operating economics deserve a closer look.

Even the accounting framework points towards this need for detail. IFRS 15 addresses the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. Recognised revenue tells us something important about performance already delivered. It cannot, by itself, establish how much dependable cash a new owner will receive in future.

Take a hypothetical managed service with customers who pay every month but can leave at short notice. Its revenue repeats, yet the contractual commitment may be limited. Maintaining it might require experienced staff, continuing customer attention and regular investment in delivery. None of this makes the business unattractive. It means that retention and the cost of earning it matter greatly.

Now consider a software product with longer contracts and modest delivery costs. It might appear more durable, but that conclusion also needs testing. Customers could be dissatisfied, the product could need expensive rebuilding or a new competitor could make renewal less likely. A long contract buys time. It cannot permanently repair a weak reason to stay.

Concentration deserves similar care. A large customer can be an excellent relationship and an important endorsement. It can also make the business sensitive to one procurement decision, a change of leadership or an internal project ending. A buyer needs to understand that exposure without treating the customer as a problem merely for being successful.

The sensible comparison therefore follows the money beyond revenue: delivery costs, ongoing product investment, working capital, customer retention and the people needed to keep the service dependable. Berkshire Hathaway's 1983 discussion of economic goodwill remains useful here. Its central concern is the earning power of a business relative to the capital required to support it. The accounting terminology has evolved, but the economic question survives remarkably well.

Acquisitions add a further complication. A buyer may see improvements that the seller has not yet made: better automation, a wider distribution network or a product that can replace some manual delivery. Those opportunities can be real and valuable. They also require investment, execution and time.

It helps to separate what the business already earns from what the combination might create. Aswath Damodaran's work on acquisition synergy distinguishes standalone value, improvements associated with control and the additional value of combining businesses. That separation makes it harder to count the same benefit twice or quietly assume that a plan has already succeeded.

There is a fair point on both sides of the negotiation. The seller built the relationships, capabilities and market position that make the opportunity possible. The buyer may contribute technology, capital and the organisation needed to realise it. Saying that all future improvement belongs to either side is usually too tidy an account of how value gets created.

The price has to leave room for the work. It should also recognise the genuine quality of what already exists. Where outcomes remain uncertain, a transaction may use contingent consideration or other mechanisms to share that uncertainty, although the terms and incentives require careful thought. There is no universal structure that makes a difficult valuation easy.

This is why I am cautious about starting with a fashionable revenue multiple. A multiple compresses a view about durability, margins, growth and risk into one number. Applying it before understanding those things reverses the useful order of the exercise.

The better conversation starts with what customers value, what it takes to keep delivering it and what a new owner can realistically improve. Once that is understood, the revenue line becomes much more informative. So does the price.