5 Variables for a Quick SaaS Valuation

SaaS continues to be hot and shows no signs of slowing down. Of course, the strong gross margins, excellent recurring revenue, and overall predictable nature of the business model make it worthy of its praise. These same characteristics also provide the fundamentals for quickly assessing a rough valuation of the business as outlined in Premium SaaS Metrics Required for Premium Valuations.

After feedback and questions on that simple valuation, it’s clear there’s appetite for a slightly more complex formula whereby a couple additional variables are introduced.

The first variable to add: gross margin. As you can imagine, a SaaS company with 90% gross margins (extremely low cost of goods sold) is substantially more valuable than a SaaS company with 60% gross margins (high cost of goods sold for SaaS). A gross margin that’s 50% higher should be reflected in the valuation of two otherwise comparable SaaS businesses.

The second variable to add is much fuzzier: market sentiment. Sometimes SaaS is hot. Sometimes SaaS is white-hot. The fastest way to assess this market sentiment is through the public markets. Take the BVP Nasdaq Emerging Cloud Index and pull an easy-to-consume revenue multiple. That is, looking at all public SaaS companies, what’s the enterprise value divided by the revenue. This revenue multiple is the fastest way to gauge market sentiment. Today, that number is 12.6. Wow!

In the previous formula there was a generic 10x multiplier. This multiplier is better represented by the market sentiment.

Now, here’s the slightly expanded formula:

Market sentiment x

Annual recurring revenue x

Growth rate (use trailing twelve months) x

Net renewal rate x

Gross margin =

Valuation

Let’s take a look at an example using today’s market sentiment multiple of 12.6.

12.6 x

$3M in ARR x

70% TTM growth x

100% net renewal rate x

80% gross margin =

$21.2M valuation

Naturally, for an imperfect market with a limited set of buyers and sellers, this valuation formula is merely a directional number as each startup is unique. For entrepreneurs wanting to understand how to think about SaaS valuations, this basic five variable equation is immediately valuable.

Investor Sweeteners in Term Sheets

During my time trying to raise money in the early 2010’s, investor term sheets were expected to have a number of strings attached — the questions were how many and how onerous were they. Now, with a much more entrepreneur-friendly market and a long bull run, investors have come up with a variety of ways to sweeten the term sheet in an effort to increase the chance of selection by the entrepreneurs.

Here are a few of the sweetener strategies:

  • Give the Founders New Stock Options – Every round of funding comes with dilution, often a heavy amount (e.g. 30%+ when an expansion of the stock option pool is factored in). One strategy is to write into the term sheet some level of new stock options for the founders (similar to a refresher grant) such that the financing round dilution is slightly less painful.
  • Buy Founder Common Stock – Founders often have the majority of their net worth tied up in the startup. By buying some of the founder’s common stock, the founder gets liquidity and the investor gets a larger ownership position. Win, win.
  • Buy Existing Shareholder Common Stock – If certain shareholders have been in the business a long time and/or there’s a substantial step up in valuation, there’s often an appetite to sell a portion of the holdings (much like dollar cost averaging out). The new investors will buy all preferred equity, then have a portion of that new capital buy common stock at 15-20% discount, and retire it. The retired common stock is an effective increase in ownership for all shareholders — common and preferred — such that the new investors gets a larger ownership percentage and existing shareholders don’t get diluted as much (the ones that don’t sell any of their holdings).

As expected, money and ownership percentages are the drivers of these sweeteners. Thankfully, entrepreneurs now have more options and investors are more creative at getting deals done. The next time you see a term sheet, look for the sweeteners.

VC Alternative Startup Financing Options

Back in the Pardot days, we had exactly one alternative financing option to venture capital: bank venture debt. While that was a great option, and we maxed out our line, being a bootstrapped startup we didn’t qualify for venture debt until we had millions of recurring revenue — an extremely high bar.

Today, there are a number of interesting alternative funding sources that are very different from venture capital, and available for startups at much earlier stages. The big driver here is entrepreneurs want to maintain optionality and/or don’t have a business that fits traditional venture capital (e.g. too small a market). Let’s take a look at a few providers:

  • Lighter Capital – Revenue financing for subscription businesses, Lighter Capital typically collects 2-8% of monthly revenue to pay back the loan until some cap is reached (e.g. 2x the loan). This model is better for a lower payout over time but requires making payments immediately.
  • Earnest Capital – A profit-sharing model where the more profit shared, the lower the equity percentage in the event of an exit with an overall higher target return (e.g. 4x the investment). Profit is defined as any salaries above some modest amount for founders as well as standard distributions/dividends. This model is better for using cash flow to grow in the near-term (payments are only required if profit is distributed) but more expensive in the long term if everything works out.
  • Indie.vc – A hybrid that can be equity or revenue financing where it’s equity if a traditional round of funding is raised but defaults to a revenue based financing model after 12-36 months where 3-7% of revenue is paid monthly until a target return is met (e.g. 3x the investment). This model provides the most direct optionality benefits but could be more expensive depending on the path taken by the entrepreneur.

Ultimately, these are all great market developments for entrepreneurs as historical venture capital was only suited to a microscopic percentage of startups striving for billion dollar outcomes. More providers serving a larger variety of startups will help grow the number of entrepreneurs that raise money, and, hopefully, help them achieve a greater level of success.

Rule of 40 and Startups

Last week I was talking to an entrepreneur and he asked what valuation I thought the market would bear for his startup’s next round of funding. I asked for the business state of the union and standard financial metrics like recurring revenue, growth rate, gross margin, burn rate, cost to acquire a customer, renewal rate, and net dollar retention.

After hearing the metrics, I shared that they’re below the Rule of 40 or better. Confused, he asked what that meant. The Rule of 40 is the growth rate, as a number, plus the burn or profitability percentage, as a positive (profits!) or negative (losses) number, added together.

If the business is growing 100% year-over-year, and is burning the cash equivalent to 40% of revenue, it would be 100 + (-40) = 60, which is 40 or better.

If the business is growing 50% year-over-year, and is burning the cash equivalent to 30% of revenue, it would be 50 + (-30) = 20, which is below 40, and not as good.

Let’s look at a more specific example:

  • $10 million of revenue
  • 50% year-over-year growth rate
  • $1 million in trailing twelve months burn (burn is 10% of revenue)

Here, the Rule of 40 calculation would be 50 + (-10) = 40. So, they’re in good shape and are right at the Rule of 40.

Another way to think about the Rule of 40 is that if the startup has a high burn rate relative to revenue, it needs to have a high growth rate. If the startup has a low growth rate, it needs to be profitable.

If some extreme cases like dramatic user growth (e.g. Facebook in the early days) and amazing net dollar retention (existing customers buy significantly more product every year and outweigh the customers that leave), the Rule of 40 is less applicable. For most startups, it’s very relevant.

The Rule of 40 is a great way to assess how a startup is performing in an objective manner and should be a regular topic of conversation for entrepreneurs.

Compounding Revenue 20% Per Year

Two years ago one of the most successful software investors in the country told me he’d never sell a SaaS business that was growing 20% per year, especially if it looked like it would grow that way indefinitely. Last month, another extremely successful investor said he just wants to invest in great companies that grow 20% per year, and doesn’t like the current mentality of growth at all costs. Clearly, there’s something more experienced investors see that isn’t appreciated enough: the power of compounding.

Let’s take a look at a couple of examples:

$10 million revenue start

  • Year 1 – $12 million
  • Year 2 – $14.4 million
  • Year 3 – $17.3 million
  • Year 4 – $20.7 million
  • Year 5 – $24.9 million
  • Year 6 – $29.9 million
  • Year 7 – $35.8 million
  • Year 8 – $43 million
  • Year 9 – $51.6 million
  • Year 10 – $61.9 million

$100 million revenue start

  • Year 1 – $120 million
  • Year 2 – $144 million
  • Year 3 – $173 million
  • Year 4 – $207 million
  • Year 5 – $249 million
  • Year 6 – $299 million
  • Year 7 – $358 million
  • Year 8 – $430 million
  • Year 9 – $516 million
  • Year 10 – $619 million

Growing revenue 20% per year for 10 years results in a 5x overall growth — the compounding effect is impressive, especially in the later years. When looking at these examples, it’s clear that growing much faster in the early years is necessary to get to a larger base by the time the 20% annual growth years set in.

Now, thinking in terms of SaaS, there’s a secret weapon that can make this compounding revenue phenomenon even more attainable: positive net dollar retention. Net dollar retention is the revenue renewal amount plus upsell/cross sell minus churned revenue. Put another way, ensure that existing customers buy more product than the amount non-renewing customers stop spending so that that the business grows forever, without signing a new customer. If you can grow new customer revenue 10% per year organically, and 10% per year with net dollar retention, that’s 20% growth. Now, do that for 10 years and you’ve quintupled the business.

Compounding is hard to appreciate for most people, especially many years out in the future. Build a business that grows fast to some level of scale, and work on the underlying fundamentals to compound revenue 20% per year indefinitely.

Revenue Financing + Traditional Equity Continued

Last week’s post Revenue Financing + Traditional Equity as the Future of Startup Funding struck a nerve and resulted in a number of comments and questions. Generally, the big idea is that most regions have sub-standard angel communities because the angels don’t make money on their investments. Without regular, positive returns, angels drop out and the community is constantly treading water. The idea for a revenue financing component is to recycle money back into the community sooner — ideally in less than five years as opposed to today’s 7-10+ years — so that angels have a good experience and stay active.

Revenue financing plus traditional equity prompted a number of questions. The big question: how might it work? Here’s a hypothetical example:

  • Angels invest $500,000 into a seed round at a $3.5M pre-money valuation ($4M post-money valuation after the new investment is included)
  • When the startup hits $4M in trailing twelve months revenue (the initial seed valuation becomes the revenue target), ideally within five years (that’s what the entrepreneur’s projections said!), the startup pays the original seed investors back, plus 20%, over the next 18 months (paid monthly as a percentage of revenue)
  • The 1.2x returned to the seed investors becomes similar to negative participating preferred equity whereby that amount is deducted from the investor proceeds at time of exit

Now, 99% of all tech startups never achieve $1M in sales in a calendar year, so most startups, even with six figures of angel investment, will never hit the revenue threshold to trigger payments back to the seed angels. Yet, if some small percentage of angel-backed startups do hit it — say 3% — then more money will flow back to the community faster.

Changing an entrenched format, like typical startup funding terms, is a tall order. When startup communities with limited angel investors come together to improve the recycling of capital, revenue financing should be a consideration.

Revenue Financing + Traditional Equity as the Future of Startup Funding

Today’s standard startup funding model whereby entrepreneurs pitch angels, VCs, and family offices for money in exchange for preferred equity is mostly a challenged, broken process. Outside of the money regions that focus on grand slams, and startups generally with revenue traction and significant growth rates, investing in startups is a great way to lose money.

The majority of angel investors I know have lost money investing in startups.

Perhaps they aren’t good investors. Perhaps it’s the entrepreneurs’ problems. Regardless, this isn’t specific to our region. It’s the same in all regions outside the money centers.

Stories of investors writing a check for $25k into Uber and turning it into $100M permeate the media, yet are so rare it’s laughable. Only, it fuels the stories and desire for more people to become investors.

One potential angel investor described it to me as wanting to spend 1% of his net worth on angel investing so that he could generate a new income stream and be less reliant on his day job. Unfortunately, the chance of that happening is slim to none.

There’s a perpetual cycle of regions trying to improve their local startup investing community. New angels come online and write some checks. They lose their money, and because of the poor outcome, will never do it again. Rinse and repeat each economic cycle.

Well, what’s the solution?

The funding model needs to change.

Over the last few years a new form of startup funding has emerged, but still represents a tiny part of the market: revenue financing. Revenue financing is code for a loan that’s paid back via a percentage of revenue. If the startup does better than expected, it’s a super high interest loan. If the startup does as expected it’s a high interest loan. If the startup does worse than expected, it’s a high interest loan paid back over a longer period of time.

Of course, a high interest loan requires the startup to pay back the debt, which takes cash away from growing the business. And, in the angel world, making 15% per year on the investment takes away the excitement and dream of making a 100x return.

The future of startup funding outside the money regions should be a mixture of light revenue financing and traditional equity.

Light revenue financing, such that the investor gets 1.2x their money back in five years, keeps startup money flowing in the community.

Traditional equity, such that there’s the potential for huge upside, keeps the imagination dreaming.

We’re near the peak of this cycle, and too much money is chasing too few high quality deals, making it a great time to be an entrepreneur. Only, this too will change — it always does.

When we come out of the next trough, and it’s time to re-evaluate the startup funding model, a combination of returning capital to the community on a consistent basis and equity upside will result in a more sustainable and successful eco-system.

A structural change in startup funding is needed. Light revenue financing plus traditional equity will improve the startup world.