How Rising Valuations Are Reshaping the Gov Tech Market

Jeff Cook, who advises on gov tech deals such as mergers and acquisitions, sees reasons to believe this year will be unlike any other for the market. Here's what's happening in the world of gov tech investment.

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I have been covering the gov tech sector for the better part of the last decade, and without question we find ourselves today in a market environment where gov tech businesses are being valued well above historical averages. From our vantage point, while anecdotal, valuation multiples are up nearly 50 percent from where they were not even two years ago.

So why is that? While no single factor can explain the increase in valuations, the confluence of higher-growth SaaS businesses, strong business fundamentals of gov tech businesses relative to broader software and technology, the growing presence of private equity-backed acquirers in the gov tech space, as well as the imbalance of supply (scaled gov tech companies) and demand (strategic buyers and investors with strong interest in the market) have all come together to drive up valuations.

How Does the Market Value Gov Tech Businesses?


At the highest level, businesses in the gov tech space are valued as a multiple of earnings (EBITDA, or earnings before interest, taxes, depreciation and amortization — a proxy for cash flow) or as a multiple of revenue. Slower growth businesses (less than 15 percent annual growth) have typically been valued based on a multiple of their earnings, while higher growth businesses (15 percent annual growth or higher) have been valued based on a multiple of their revenue. While that’s an overly simplistic view of the world, it’s a good rule of thumb.

Driver #1: A Shift from Earnings-Based to Revenue-Based Valuations


So how has it changed? Five years ago, the gov tech market looked much different — many of the transactions involved larger, slower-growing businesses and, accordingly, almost every business was valued based on their earnings — a valuation based on a multiple of revenue was very rare. Today, the complexion of the market looks dramatically different as the overall gov tech market’s transition to SaaS has happened faster than anyone expected, which in turn has created a large cohort of SaaS businesses that are growing rapidly to meet the market’s demand for cloud solutions. Accordingly, these higher-growth businesses are being valued as a multiple of their revenues and are becoming a much larger overall percentage of the transactions in the market. What that has meant for the gov tech market is that these businesses are now being valued more similarly to typical software businesses that are valued more off their growth potential than their earnings.

Driver #2: Strong Business Fundamentals Relative to Other Markets


Another major driver has been strong performance of gov tech businesses relative to businesses in other technology sectors. At a high level, what we have seen is that gov tech businesses typically do not grow as fast as businesses in other sectors (due to longer and more complex sales cycles for new customers), but typically outperform on other financial metrics that determine valuation such as customer retention, gross margin, revenue predictability and cash flow. Simply put, if you took a snapshot of businesses from across different sectors, you can bet that a gov tech business will usually benchmark very well on key financial metrics versus other industries. So why does that matter? Strong relative performance gives investors a reason to value gov tech businesses at or above where valuations are in the broader software markets.

Driver #3: “Trickle Down” Effect of Software and Tech Valuations


The broader increase in valuations of software and technology companies have also been major drivers of the rising valuations in gov tech. Many larger gov tech business ($50 million or more in revenue) get a new round of investment at a high valuation because of strong business fundamentals relative to the broader software and technology markets, and the primary emphasis from the new investor is to grow faster through mergers and acquisitions. Those companies in turn look down-market to the $15 million or lower businesses and aggressively pursue those that are strategically compelling, eventually valuing them at a similar multiple where the larger business was valued. More likely than not, that acquisition target ran a sale process inclusive of other strategic and private equity investors and so the other buyers that lost out understand where the company was valued at the end of their process, and voila — a new precedent for market valuations has been set.

Driver #4: Rapidly Growing Interest in Gov Tech from Both Strategic and Private Equity Investors


Last but not least (and potentially the most important factor) is the strong demand among strategic buyers and private equity investors in the gov tech market. We speak with a countless number of buyers, seemingly more each month, that have developed a thesis in the market and are looking to invest behind that thesis. And while there is a vibrant and growing gov tech ecosystem, at any given time the number of interested buyers dramatically outweighs the number of interesting and actionable gov tech businesses. So when a gov tech business decides to launch a sale process there typically is a long (and growing) list of interested buyers and investors. As in any sale process, competition creates bidding wars, which creates rising valuations, and gov tech is no exception.

What Does It Mean?


Why this all matters it that we are poised for among the most active years in recent memory in the gov tech space. We fully expect that when we look back on this year the market will have set records for number of deals, total value of deals and the valuation multiples associated with those deals. Many companies we speak with are doing the simple math of what their business is valued today based on current valuation multiples and — expecting a return to more normalized valuation multiples in the medium term — coming to the realization that selling today could result in the likely valuation they were expecting in 12-18 months. And then there are potential changes in capital gains taxes that could make the math today even more compelling. So, from our perspective, we expect more sellers to “test” the market given the current climate and continued strong demand from buyers, and so we anticipate a busy and interesting remainder of the year and a landscape that could look very different by the year’s end.

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Jeff Cook is a managing director at Shea & Co., an investment bank that has advised in more than 20 gov tech deals (investments and exits) in the past 5 years.
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