It seems like every few months there is news about a multi-billion dollar acquisition in the tech sector. As opposed to more traditional sectors where the valuations are comprised largely of tangible assets, the tech industry tends to weight the intangible asset of goodwill very heavily.
In February of 2014, Facebook (NASDAQ: FB) Founder and CEO Mark Zuckerberg purchased WhatsApp for $19 billion. Just one year prior, Sequoia Capital had invested $50 million at a $1.5 billion valuation. Upon acquisition, WhatsApp was still making very little revenue, yet it had a monthly user base of roughly 450 million. This is where the power of goodwill comes into play.
Like WhatsApp, many technology companies place a heavy focus on the intangible asset portion of their budget sheets and rely heavily on user base over immediate explicit revenues. This makes sense, however, as getting enough eyeballs on a platform may very easily lead to future revenue, and associating a price tag with an early-stage project drives off many early-stage adopters.
Thus, goodwill valuation is often the focus of consumer software startup executives. A savvy early-stage investor, in return, gives careful attention to startups’ business plans dealing with acquiring a large and consistent user base. Just as important is a well-defined strategy that outlines exactly when and how their following may be converted into profit.
Converting the qualitative forecast value of a business plan into a quantitative hard figure in the balance sheet is no easy feat. This is where the double-edged sword comes into play. If an investor is too wary of an intangible asset being weighted so heavily in the valuations, they may incur a great opportunity cost. On the other hand, overzealous investors may pour extra cash with inflated expectations of profitability from the given user base and incur a direct loss.
Because it is next to impossible to successfully invest in consumer software without proper goodwill valuation, it is advisable for investors to diligently review the business plans of prospect companies for:
Solid plan for growing user base
Definitive numeric goal for when focus will shift from growing user base to monetization
P10, P50, and P90 forecasts for user base and profitability goals; Monte Carlo simulations are helpful
Exit strategy (as always)
Goodwill valuation is nothing to fear or scoff at and is often the crux in consumer technology investments.