SIE and VIE ratios: more magic numbers for software companies.
What’s the best way to determine the capital efficiency of a software company? And why does it matter? The sales/investor equity ratio, or SIE ratio, is one metric to compare the relationship between an organization's sales and its financial leverage. It’s a performance ratio that lets the business know how well it is doing converting equity into growth. For private companies, it becomes more challenging to estimate their SIE ratio without providing their trailing sales, but using the number of employees provides a very good approximation.
Perhaps the more important ratio for determining the capital efficiency of a software company is valuation/investor equity, or VIE. VIE is the exit valuation estimate divided by the investor equity; it provides the estimated gross return on invested capital.
In a NextPath study of 111 Northwest software companies ranging in estimated revenues from $1M up to $48M, we used an exit multiple of five times trailing revenue to run VIE comparisons. Fortunately, data on investor equity per company is available from several sources; it’s important to note we omitted IRR because we didn’t have the precise timing of investments. For this exercise, we set a benchmark assumption that the companies have 50% of their stock owned by investors and a minimum 3X target return on capital, which yields a representative VIE score of three divided by 50% for a VIE target of six.
The results of the study were very telling. Here are the findings at a 5X trailing revenue multiple:
The average VIE was 7.2, which sounds good against a target of 6. But, the VIE scores ranged from 0.45 up to 74!
What’s more interesting is the median VIE was 3.0. So, half the companies are returning less than 50% of their minimum target score—assuming they could even get the 5X multiple on exit.
For VCs, the vast majority of their returns come from 20% of the portfolio, so it’s not a surprise that a lot of their portfolio may not be operating at optimal capital efficiency. The VIE ratio gives these investors a better way to rank their future investment opportunities.
For CEOs, the implications of the VIE ratio are more specific:
If your company is tracking above a VIE of six, along with a strong YTY growth rate (50%+), then you’re showing good capital efficiency and a potential for a favorable exit. Moreover, you’ll likely have excellent access to funding as needed.
For those with VIE of 3 to 6 with a modest growth rate, it may be time to look to new growth channels to improve your capital efficiency and start considering how best to position your exit. You may be able to get some money from existing investors to execute on a well thought out plan.
For those with a VIE under 3, it’s going to be very tough to raise money, and it may be time to start planning for a pivot, an exit, or prepare your three envelopes.