Investors have long had a love affair with technology but there are certain characteristics to be mindful of when investing in the sector to safeguard your cash and ensure long-term growth.

Why are software companies valuable even though they are loss-making? Furthermore, how does a company which is loss-making generate such exorbitant valuations often into the hundreds of millions or billions of dollars?

Tech-focused growth capital fund Bailador Technology Investments (ASX:BTI) co-founder and managing partner Paul Wilson said companies are generally valued based on their expected future cashflows.

“A company can be making losses today, but if it is expected to make big profits in future, it is considered valuable,” Wilson said.

“Particularly if it scales efficiently, which means that it can grow revenue much faster than the growth in expenses.”

Love affair with tech

Throughout history investors have long wanted to be a part of the next big thing – think the industrial revolution or the enormous railway expansion in the US depicted in Paramount’s The Gilded Age. 

Or you could consider Thomas Edison, who founded the Electric Light Company and acquired more than  1,000 patents (singly or jointly).

Edison was a driving force behind inventions such as the phonograph, the incandescent light bulb and motion picture cameras.

Throughout history new technologies which changed the world and the bold who invested in them have led to some great riches… but be warned.

“For every Elon Musk there are thousands who don’t get it right or don’t make it and technology is a high-risk and high-reward area,” Wilson said.

Since listing on the ASX in 2014, BTI has been steadily growing its NTA with tech winners.

Software companies have been a key part of Bailador’s portfolio.  Wilson said that there are good reasons that a software company that’s loss making today could be very valuable, but it pays to be selective.

Bailador looks at over 100 companies a year, and usually only invests in one or two.  While they are not the only ones, here are four elements Bailador considers in a software company.

1. Efficient Scaling 

He said in simple terms, software companies efficiently scale by selling the same thing thousands of times without having to make more.

“Once the software platform is built, it doesn’t really matter if there are 10 users or 10,000, the cost to serve them is pretty much the same,” he said.

“If you compare that to a manufacturing company, if a plant is selling everything that it can make, you need to build another plant to double capacity.”

He said tech companies do have to consider the cost of servicing customer queries, but the process is mostly automated.

“The cost to serve increases only fractionally even with a vastly higher number of users,” he said.

2. Repeat Revenue

Most people have heard the term Software as a Service or SaaS, which is where customers don’t just buy the software once but sign up to a repeating subscription.

“They are effectively renting the software,” Wilson said.

“Customers sign up to SaaS because it’s a cheaper up-front cost than buying the software outright.

“Ongoing upgrades to the software are usually included, rather than having to upgrade and buy new software every couple of years, as we used to do.”

He said for the software company, the repeating subscription revenue is very valuable, providing an ongoing predictable revenue stream.

“They don’t have to go out and make a new sale every time to get revenue but just provide a good enough service not to lose the subscription.”

3. Strong Unit Economics

Wilson said there are a lot of metrics used to measure the health of a software business.

“One that is straightforward to understand and goes straight to the heart of why a tech company can be valuable is over the life of a customer, how much gross profit will it expect to get from that customer, compared to the cost to acquire them?” he said

He said this metric is called “Life Time Value/Customer Acquisition Cost” or LTV/CAC for shorthand.

“If a company is making profit over the life of a customer of say 5x the amount that it cost to acquire that customer, it clearly makes a lot of sense to go on acquiring customers,” he said.

“If a company has good unit economics, it can make losses in the short term, knowing that it will make much greater profits over the life of the customer.”

He said this a very simplified example, but it’s why some tech companies can make losses, but still be very valuable.

“Companies can be making losses but if you can dig in and see as long as we don’t lose those customers for a period then it will be very profitable.”

4. Size of addressable market

Finally, Wilson said it’s important that the company in question is addressing an extremely large market to take best advantage of economies of scale.

“If a business breaks even at 1,000 customers, but there are only 2,000 potential customers for its service, then it probably shouldn’t have a high valuation,” he said.

“But if there are one million potential customers, then profits can grow to be very large, and so can the company valuation.”

Wilson said it’s one of the reasons that BTI has regularly backed Australian tech businesses with strong unit economics that are addressing a global market rather than just local and can become extremely profitable by addressing a huge market.

“The skill is in evaluating which companies have a compelling product market fit and strong unit economics sustainable over a long time because many won’t,” he said.

He said BTI looks at more than 100 tech opportunities yearly, and only selects a couple. It has a knack for picking winners and was an early investor in (ASX:SDR).

“To get them to our evaluation they need to be generating around $10 million per annum in revenue, showing you’ve got plenty of customers, it’s scalable and can address a big market,” he said.

“If a company has proven its product, and is scaling efficiently, that’s the stage that we invest to help them to get really big”

This article was developed in collaboration with Bailador, a Stockhead advertiser at the time of publishing.

This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.