There are no straight forward answers when it comes to valuation. As Aswath Damodaran, professor of finance at NYU, an expert on Valuation says “Valuation is a bridge where narrative meets numbers”. Engineering founders have trouble coming to terms with it. Many find it unbelievable why certain startups command crazy multiples.
There are certain guidelines that startup founders should be aware of, which will come handy when they consider an investment into their company, a strategic partnership or an acquisition.
Starts with Narrative first
First and foremost, the narrative of your business is equally or more important than your business. Seems confusing? Ask seasoned investors! They will tell you that the businesses they have invested in are based on the entrepreneur’s depiction of the tailwinds and market forces, recent activities in the same space, entrepreneurs clarity on portraying a treasure island and the entrepreneurs’ confidence and ability to get to that treasure island.
Secondly, understanding the investor/buyer is critical for the success of the startup to get the best valuation.
Every institutional investor goes by their funds’ philosophy which is their own narrative and that dictates their investment.
Similarly, every strategic partner or acquirer is moving towards a treasure island (however slow or fast) and wants to know how your business can help them move faster and inevitably towards the treasure.
The more you know these, the better you can play your cards and maximise your advantage.
Numbers yet not an Exact Science
Finding this hard to believe? Look around, and you will discover that some startups have the ability to command a 50x multiple of revenues and some 20x, while many only get single-digit multiples.
Only the very mature public listed companies are valued at standard multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), Revenue or other industry specific parameters.
At a very early stage with no predictable revenues and no profitability, an investor looks at “cost to duplicate” (how much will it cost to get here) as a method for valuation along with “market multiple” approach (how much will the market be ready to pay based on recent activities).
The more quantitative methods of valuation are used by Private Equity and growth stage Venture Capital Investors.
Valuation in general
While there are many methods of valuation for very-early, early and mid-stage, and late-stage startups, here are 9 methods discussed in an easy-to-understand post, using a value box analogy:
A rough estimate of how much dilution is acceptable to founders and market comparables is the biggest driving force in most VC investments, which means it eventually boils down to your negotiation skills and the market your business is in and your market positioning.
For clarity on what is a SaaS business, you should check out this post by Prasanna
Some of the key considerations for valuations in SaaS are:
- Recurring revenue size
- Revenue Quality – Customer segmentation to assess risk of shrinkage
- Growth – Year over year, and month on month
- Churn – Customer and revenue loss from current base
- Expansion Revenues from existing customers
- Customer Acquisition Cost, Lifetime Value, Payback period
- Gross Margins
- Market size
- Team – Founder market fit
- Benchmarking – Comparables
SaaS valued on ARR and not EBITDA
For a SaaS business, net income takes a longer time to materialise even though the underlying unit economics can be good. Sales and marketing expenses are realised upfront. This makes new customers unprofitable in the short term.
As the business grows and acquires more customers, this problem worsens (as you are spending even more upfront), even though the customers end up being profitable over their lifetime. For these reasons, Annual Recurring Revenue is a better indicator than Net income or EBITDA.
Consequently, you will notice that there is little to no relationship between valuation and profitability for SaaS startups.
Valuation during acquisition
Basically, if your startup is not growing, the multiple could be as low as 1x of ARR.If your startup is perceived as a winner, valuation multiples could be as high as 50x of ARR. An established SaaS company doing well may command 8x to 12x of ARR
A potential category killer could be acquired for 2x to 3x of previous post money value irrespective of the ARR.
Valuation of public SaaS companies influences private SaaS startups
Public SaaS companies trade at a Public multiple; this is calculated by taking the Enterprise Value of the Company and dividing it by ARR (Revenue when ARR is not publicly available) ie. public multiple = EV/ARR (or Revenue). This multiple ranges from 5x (for companies like twilio and box) to 15x (for companies like Atlassian and shopify).
The most recent IPOs are killing it with Docusign, Smartsheet, Z-scaler, Zuora having traded at 15x revenues.
However, The median valuation multiple of public SaaS companies which reached a high of 9.5x in 2018 is now less than 8 and the mean is approx 9.
In an analysis by Tomasz Tunguz in his latest blog, he presents this:
Many investors tend to value private SaaS startups based on similar multiples that public SaaS companies trade at. They arrive at pre-money valuation of private SaaS startups based on similar multiples * ARR.
This is a fair proxy for startup valuations when there is nothing extraordinary or nothing bad about the performance of the startups. Basically, if public investors are willing to pay more or less for each $ of recurring revenue, ARR focused average startups get positively/negatively affected by the trend.
Valuation in private Investments
Some investors and acquirers make it more scientific once they have the above multiples for SaaS startups.
They factor this by YOY growth rate and YOY renewal rate.
An easy to use formula that emerges is the following
SaaS Valuation = ARR * Multiple * YOY Growth % * YOY renewal rate %
However this model tends to breakdown when the growth or renewal rate is low.
Yes, Valuation for private investments is still fuzzy. It can be frustrating for entrepreneurs and investors. Many private SaaS startup investors especially PEs and growth stage investors have internal methods of deriving a precise ARR multiple for arriving at valuation.
One such method explained in significant detail is in the White Paper “What’s Your SaaS Company Worth?” by SaaS Capital, available to download:
I am summarising the 15 pages of this white paper through my own example:
There are 2 key questions:
- What are public SaaS company multiples?
- How fast is your business growing relative to your peers (businesses of similar size)?
These 2 pieces of market data gives you 75% of the answer.
For Eg. consider median public SaaS company multiple is 8x (as discussed above) at the time of investment.
This 8x is subtracted by 0 to 1.3 for private multiple (because the public SaaS value is liquid/cashable). That makes it 8x to 6.7x as the private multiple. The bad news is during recent times this discount is more towards 1.3 and not towards 0.
Now if your business is growing faster than your peers of similar ARR size, you command a premium. A rule of thumb would be if your business is growing at twice the median growth rate, the valuation multiple would grow by 50%.
So, if you are a $2M ARR company and the median growth rate is 50%, and you are growing at 100% YOY, then your multiple becomes 12x to 10x
The other 25% for the answer, comes from internal metrics. These metrics are mainly the following:
- Addressable market size
- Retention rate
- Gross Margins
- Capital efficiency
The above 4 metrics affects the multiple (to an additional 25%) as follows:
If your net retention rate is greater than 100%, you get a premium. Similarly, there is additional premium if gross margin is greater than 85%, if customer payback period is less than 12 months, and if the addressable market size is greater than $1 Billion
Overall this can take the multiple to 16x to 13x (based on 25% contribution to the overall multiple). It is to be noted that when these 4 factors are not at desirable levels, it can shrink the multiple and bring down the multiple to 9x to 7x in this example.
You can see from this example that the valuation multiples can vary anywhere from 5x (when growth is not above median growth rates) to 16x for a Startup that is doing well on all all its metrics.
The rest is positioning your business strategically (why better growth will happen now?) and negotiation (does the investor want to do the deal badly?).
What can you do to increase valuation of your startup?
- Increase Month on Month and YOY growth rate. This is the single biggest factor to help you prove you have a stellar business. The desired growth rate depends on stage and size of your business. Absolute growth and Growth persistence (what % of last YOY are you able to do this YOY?) are important.
Here is SaaS capital report on median growth rate of 900 private SaaS companies as of 2017:
The key takeaway is that the median growth rate of the startups declines as revenue levels increase. Startups with less than $1M ARR have a median growth rate of 60% while median growth rate of startups in the $1 M to $5 M ARR range is about 45%. At nearly all revenue levels, SaaS companies that bill annually in advance grow faster than their peers that bill monthly.
- Reduce Churn; retain all or as many of your customers; shows customers love you. This varies with the market you are addressing including SMB vs Enterprise. At early stage, higher churn is acceptable. You should watch out whether you will hit a ceiling in your growth because of your churn. Here is a calculator that will tell you when your business may die?:
- Expansion of existing customers; helps tremendously to make your churn net negative. Invest in customer success (not support only)
- Secure your IP (trademarks, IP assignment)
- Avoid discounting; increases revenues and also shows you have control on pricing.
Increase Annual Contract Value (ACV) /Average Revenue Per User (ARPU) over time. This does help increase revenues and also drives your business to focus on value to customer.
Maturity of your business; How is the financial discipline? Are SaaS metrics being tracked accurately? Your SaaS metrics are of vital importance to knowing the health of the business; simple things such as Monthly Recurring Revenues (SaaS MRR vs Revenues), Customer Acquisition Cost (CAC), Customer Lifetime Value (LTV), Revenue & Customer Churn.
As your startup matures, you need to keep your gross margins high (Revenue – SaaS COGS; 85% is desirable). You will need to Improve customer payback period (how long does it take to earn the money invested in acquiring customers) and keep it below 12 months. For bootstrapped companies you should keep this period as low as 3 to 4 months so that your cash in the bank does not run out. Monitor your net revenue retention (from existing customer base) and work towards having net negative churn (revenue expansion from existing customers higher than revenue lost). Churn is ok as you explore and find product market fit, but once your ideal customer segment is identified, your churn has to stay low (1% to 2% a month). This churn % varies based on you target market too. SMB market tends to have higher churn than Enterprise.
Equally important is to ensure your business is structured appropriately. Where is your HQ and your subsidiaries? Where is revenue recognised? Who owns the IP? Are legal agreements in place? If you have already raised money from an institutional investor, you must have fixed this as part of their due diligence. If not, you don’t want your startup valuation to be affected because of a long list of CPs (Conditions Precedent) to an investment.
There are many other aspects of SaaS business maturity such as metrics on repeatability, productivity, customer satisfaction, organisational structure, innovation roadmap and such that are not in the scope of this discussion but will help you negotiate a better value.
- Focus on user needs & value chain (a framework such as wardley maps https://www.cio.co.uk/it-strategy/introduction-wardley-value-chain-mapping-3604565/) Outsource things that are not your core business value or things that are already commoditised; this reduces potential buyers replacement costs, and more importantly it helps your business focus on increasing value to customers and thereby help you position strategically to your potential investor.
Like all businesses, any SaaS business is worth what the buyer and seller can agree upon.
The basic valuation formula is ARR * Multiple.
Macro factors such as valuation multiples of public traded companies, tailwinds, recent activities & market comparables, and startup specific factors such as growth rate, renewal rate, gross margins, capital efficiency, churn/expansion, market size, quality of revenues will impact this multiple.
Understanding what constitutes ARR is critical as it has a direct and biggest impact on valuation. A general assumption is any revenue stream that is recurring but there are a lot of nuances to it.
An acquisition/investment by a strategic partner, where your startup will be instrumental in taking them to the treasure island faster will command the highest multiple. Early stage investments by Angel/Seed investors and Series A VCs will have a wider range on the multiples based on the company specific factors listed above. Strategic positioning will help you get crazy multiples in these cases.
Investment by Growth Stage VCs, PEs and IPOs will be at multiples derived more scientifically and will be within a defined range as discussed in the example above. Private SaaS multiples are discounted from Public SaaS multiples because of the lack of liquidity (ie. their value is not cashable). Public multiples are dependent on the market conditions at the time of IPO. While PE investment multiples tend to be the lowest of these, they do exercise creative models to help founders cash out on secondaries and continue to have equity and skin in the game.
By understanding the basic methodology used by Investors and Buyers, you can and should be able to optimise and negotiate an appropriate valuation. Positioning strategically will be your biggest leverage.