Last week I was talking to a growth stage software investor. We were discussing a recent round they lead and I asked how they thought about the revenue multiple for this SaaS business. Revenue multiple? I was quickly corrected that they didn’t underwrite it as a Rule of 40 multiple of recurring revenue, growth rate, and gross margin (see Rule of 40 Valuations). Rather, they made the investment based on an estimated EBITDA, and EBITDA multiple, five years from now.
Coming from the grow-at-all-costs for several years to the current grow-reasonably-efficient times, making the leap to EBITDA multiples isn’t as dramatic, but it’s still problematic with so many software companies burning cash. EBITDA (earnings before interest, taxes, depreciation, and amortization) is form of profitability calculation made popular by the Cable Cowboy John Malone many years ago. In rough numbers, a smaller business is worth 4-6x EBITDA, a mid-sized business is 6-8x EBITDA, and a large business or one with an exceptional business model is 10-15x+ EBITDA (also varies dramatically by industry, growth rate, etc.).
SaaS companies, due to characteristics like the stickiness of the product, high gross margins, revenue predictability, and more make for an exceptional business model. Let’s do some basic math to see how a growth stage investor might underwrite a SaaS company at scale to make 3-5x the investment in five years.
$80M pre-money valuation
$20M investment for 20% ($100M post-money valuation)
End of Year 1
End of Year 2
End of Year 3
End of Year 4
End of Year 5
This is a fairly basic example with a static $7M revenue growth per year (meaning the growth rate slows each year with scale) and tremendous EBITDA growth in the later years due to economies of scale and a higher base of recurring revenue.
Here with a $50M revenue software business, $20M of EBITDA, and a 15x EBITDA multiple, you arrive at a valuation of $300M. A sale of $300M returns 3x the original investment, assuming no further dilution along the way, and the investors achieved their goal.
Theoretically, businesses should always have a floor valuation that’s based on the expected value of the future cash flows. For SaaS and other SaaS-like business models, this is a good exercise to think through potential valuations from a cash flow multiple perspective.