A subscriber asked me the other day why I did not recommend buying a software company. In fact, I do recommend buying a software company… if it is cheap. However for first, or even fifth time buyers I think it is a good idea to stay away from high tech companies in general for a number of reasons. Software companies may or may not be high tech companies. I have also said this about low tech service companies as well. But right now let’s discuss high tech companies and define them.
A high tech company is one in which new technology is the driving force behind the business model and as such it is still in a relatively early stage in its development. It may be showing profits or not, but in theory it is in an upward growth curve and this will be the main factor in pricing and valuation. A high tech company may or may not produce a physical product. This does matter. Products are often more bankable than humans. Software products are not hard bankable assets.
Examples of high tech companies, in the smaller market that is, could be software companies, IT companies, biotech companies, electronic device manufacturers, high tech components, new inventions and so forth. You will probably know when you encounter a high tech company for sale when you get a case of sticker shock from the price tag.
So I think we can now proceed to explain why it isn’t a good idea to buy a high tech company:
- The balance sheets are usually weak. They may be startups, they may be software companies with no assets but usually a high tech company has not had time to develop a strong balance sheet.
- The valuation multiples will be astronomical. This is because there usually is a growth curve that is being factored in. Sometimes valuations are priced off of revenues instead of profits… because there aren’t any profits. High tech companies are particularly hard to value as their success must be measured in terms of future projections rather than proven performance.
- The historical performance is usually unstable. This is because the tech company is new. If it isn’t at least relatively new then it probably isn’t a tech company, at least not any more. Unstable performances, even if they reflect an upward trend, which they should, are not desirable and often not bankable as lenders are suspicious of high flying upstart companies.
- The industry is usually vulnerable. Vulnerable meaning vulnerable to competition and startup risk factors. The technology may be untested and it is not yet clear whether the industry is viable in the long term. The technology must also be protected from competitors and employees alike.
- The industry is highly specialized. This means that employees must have very specific skills which are hard to replace.
To sum, one does not buy a high tech company as a predictable income generator with a reasonable valuation. These companies are bought as future investment and are priced accordingly. However, having narrowly defined high tech companies and proclaiming them untouchable, I can also say that there are all kinds of exceptions. There are tech companies that are no longer growing, there are software companies that are low priced, tech companies that have good balance sheets and there are even online companies that were high tech yesterday but are nearly obsolete today.
High tech company multiples can get to 6-10x as they settle down and make money – much higher if they are legitimate venture capital plays. Most would typically appear out of reach for most small buyers anyway. Venture capital should be interested in these deals but they usually aren’t, since only the best startups get the VC money. As the EBITDA climbs PE firms may have some interest and the company becomes less of a high tech target and more of a high earner. As the multiples get lower the deals become more attractive. That’s the main thing to watch, is for the lower multiple which means a smaller more approachable company.
On the other end of the spectrum there are many online plays at 1x-2x which hardly qualify as high techs but do qualify as potential cash flow machines, albeit with no assets. Depending on the deal these aren’t precisely businesses but more home based opportunities. Take a look at Flippa for a complete range of deals making anywhere between zero to $10,000 a month and up.