David Cummings on Startups

Category: SaaS

  • The Difference Between a 3x and 10x Multiple for SaaS

    Software-as-a-Service (SaaS) valuations continue to be high, and I believe they’ll be cut in half over the long run. Now, some SaaS companies, even in our current climate, trade in the 2-3x revenue multiple range (see Constant Contact). As startups pitch institutional investors, the inclination is to shoot for the big valuations, as that’s human nature, often referencing the public market multiples as a basis. Only, when making the comparisons, and thinking about valuations, there’s one major driver: growth.

    Think about it this way. If a startup is growing at 9% per year, according to the rule of 72, it’ll take eight years for the business to double (72/9 = 8). If a startup is growing at 40% per year, it’ll take almost two years for the business to double. So, the valuation multiple is driven by the historical and expected future growth rate, all else being equal. With a super high growth rate, it doesn’t take long for the business to be substantially larger, and thus significantly more valuable.

    When an entrepreneur talks about valuations in the 10x revenue range for SaaS companies, find out the growth rate and see if the math makes sense. Big multiples require big growth rates.

    What else? What are your thoughts on growth being a major driver for SaaS valuations?

  • SaaS Company Valuations Will be Cut in Half

    Earlier today Jason Lemkin tweeted that a 50-70% correction is coming to Software-as-a-Service (SaaS) companies:

    I agree.

    Last week Fred Wilson wrote a post The Bubble Question about it where he attributes overvalued tech stocks to interest rates near zero and the desire for growth companies.

    Today, many SaaS companies are trading at 10-12x trailing twelve months revenue, and have no profits. So, why do I think they’re 50% overvalued? Easy. SaaS companies typically spend 40-60% of revenues on sales and marketing to acquire customers (growth is incredibly important). Assuming these sales and marketing costs could be pared back relatively quickly, the theory goes that these companies would quickly achieve 30-40% profit margins.

    The average historical price to earnings (PE) ratio is around 15 for a public company. That is, the company is worth roughly 15x profits (right now the average PE ratio is almost 20).

    If a public company is worth 15x profits, and a SaaS company can quickly achieve 33% profit margins, that results in the same valuation as 5x revenues (15*.33 = 5). 5x revenues is half of the 10x revenues many SaaS companies are trading at now, thus long term, the valuations should be cut in half.

    Of course, this is simplistic in that it isn’t accounting for growth rates, gross margins, renewal rates, total addressable market, premiums for a public company over a private company, etc. But, as an example, if a company is valued based on a function of its future profits, and SaaS companies can become extremely profitable due to the nature of the business model, making a guess as to profit margins results in a straightforward valuation.

    What else? What are your thoughts on SaaS company valuations being cut in half?

  • Evaluating the Purity of a SaaS Business

    Recently I was talking to an entrepreneur that has sold his last company and is actively looking for a new business to either start or join. As we got to talking, it became clear that his goal is to get involved with a pure Software-as-a-Service (SaaS), as opposed to a tech-enabled business service where there’s a hybrid between proprietary technology and human-powered services. Some of his drivers for a pure SaaS business include higher valuations at the same revenue levels, greater economies of scale, and perception that there are better opportunities.

    Assuming a pure SaaS business is the goal, here are a few financial model considerations to contemplate:

    • Gross margin (especially at scale e.g. > $20mm in revenue)
    • Cost of customer acquisition
    • Lifetime value of the customer
    • Renewal rates
    • Scalable lead generation

    The ideal SaaS business will have high gross margins (> 80%), low cost of customer acquisition (< first year’s revenue), high lifetime value of the customer (many times the acquisition cost), high renewal rates (> 90% per year), and copious amounts of leads.

    When thinking about SaaS metrics, it’s important to review Insight’s Periodic Table of SaaS Metrics and Omniture’s Magic Number.

    What else? What are some other ways to evaluate the purity of a SaaS business?

  • Lead Generation as the #1 Challenge for SaaS

    Continuing with yesterday’s post on SaaS Company Premium Valuations, there’s an important point about the SaaS business model that isn’t well understood. With all the talk about finding product/market fit followed by building a repeatable customer acquisition process (see the 4 Stages of a B2B Startup), it’s regarded that with enough time and money, both of these tasks will be accomplished. Assuming there’s sufficient need in the market, and enough resources, product/market fit can be achieved. Only, it’s the repeatable customer acquisition process that’s also capital efficient and profitable where there’s even more difficulty. Customer acquisition that’s capital efficient and repeatable starts with lead generation.

    Here are a few thoughts on lead generation as the #1 challenge for SaaS:

    • Cost of customer acquisition relative to the first year’s customer revenue is one of the driving metrics for building a SaaS business, and lead generation is the top of the funnel for customer acquisition
    • Company size upper limits are determined by the number of new customers signed relative to customers that leave (churn) and is also accentuated by the law of large numbers that makes growth more difficult at scale
    • Acquiring customers in a manner that is scalable and profitable isn’t always possible, which is why many entrepreneurs give up on building out a sales team due to repeated failure (the lower cost and higher volume of leads can be generated, the greater the chance for a profitable and repeatable customer acquisition process)
    • Top of the funnel lead generation is the most difficult to plan and control for — once a lead is in the pipeline, automated nurturing and human selling is very controllable

    The next time an entrepreneur talks about how hard it’ll be to scale the service for a large number of users or get the user interface just right, ask the harder question about how they’ll generate a huge number of marketing qualified leads.

    What else? What are your thoughts on lead generation as the #1 challenge for SaaS companies?

  • SaaS Company Valuation Premiums

    Valuation is one of the favorite topics of conversation when it comes to Software-as-a-Service (SaaS) companies. While normal companies might be valued at 4-6x their profits, unprofitable fast-growing SaaS companies are often valued at upwards of 10-14x revenue (e.g. see ChannelAdvisor trading north of 12x revenue net of cash on hand). Jason Lemkin, a partner at Storm Ventures, highlights a number of solid reasons why SaaS isn’t a bubble, even if it’s overvalued.

    Here are a few reasons why people are paying a premium for SaaS companies:

    • Generational shifts are taking place within the software industry where everything is moving online, and the vast majority still isn’t web enabled
    • Few companies are growing fast, let alone experiencing hyper growth with no signs of slowing down
    • Subscription (recurring) revenue combined with strong gross margins and high renewal rates results in one of the best business models anywhere
    • Opportunities to consolidate competitors and create more economies of scale abound
    • Most SaaS companies spend a disproportionate amount of revenue on sales and marketing to fuel growth, and can turn it off (with some pain) such that they’d become extremely profitable

    While I believe SaaS companies are overvalued due to a lack of growth companies in general, there’s still tremendous growth ahead that bodes well for the sector. With strong growth rates and renewal rates, SaaS companies are going to get a premium over their peers.

    What else? What are some other thoughts on SaaS company valuation premiums?

  • Custom Work to Win SaaS Deals

    As a follow-up to Balancing Desire for Full Paying Customers with the Need for Discounting, I was asked about doing custom work to win a deal. For example, statements like “I’m very interested in your product but it has to do X before I’d buy it” are common from prospects. For Software-as-a-Service (SaaS), this is even more interesting because SaaS should be a true multi-tenant architecture where everyone uses the same product.

    Here are a few thoughts on custom work to win SaaS deals:

    • Never give something without asking for something in return (e.g. sure, we’ll do 5% off our product in exchange for a case study)
    • Always debate if the custom work request is going to be applicable to 80% of the desired customers (e.g. custom work is OK if it really is going to be used by everyone else)
    • When evaluating a custom work request, get a letter of intent that the prospect will buy the product before implementing the new feature (e.g. the prospect has to show some level of commitment before engineering resources are applied)

    Custom work and product enhancements often come up in a sales cycle, regardless of product type. The key is to have a gameplan and evaluate it on a case-by-case basis.

    What else? What are some other thoughts on custom work to win SaaS deals?

  • Automatic Product Pulse With Google Spreadsheets

    Github, the largest source code hosting and collaboration platform, has a great built-in tool call Github Pulse. Github Pulse highlights key aspects of a project like number of authors, commits, pull requests, open issues, closed issues, and more in a designated time frame (e.g. 1 month). The same way Github Pulse provides an automatic dashboard of a project, startups would do well to build an automated pulse of their product usage using the Google Spreadsheets API.

    Here’s how an automatic product pulse with Google Spreadsheets would work:

    • Blank Google Spreadsheet with columns for each piece of relevant data and a new row for each day of data
    • Nightly cron job to insert a new row of data based on the previous day’s data in one or more sheets
    • Example columns: New accounts, deleted accounts, new account revenue, deleted account revenue, new users, deleted users, active users, user logins, # module A created, # module A updated, # module A used, # module B created, # module B updated, # module B used, etc (where each number represents the amount for that one 24 hour period)
    • Charts and graphs would automatically update based on data

    Overall, the idea is to spend a few engineering cycles to build a system that automatically sends data on a regular basis to a cloud-based spreadsheet so that everyone in the company can see the most important information at a moment’s notice. Taking it one step further, the product pulse could then be displayed on a large LED TV, much like a LED Scoreboard, so that the most important product metrics are always top of mind.

    What else? What are your thoughts on an automatic product pulse with Google Spreadsheets?

  • SaaS Startup Funding Between an Angel Round and a Series A

    With all the success and publicity around Software-as-a-Service (SaaS) companies, a number of new startups have emerged. Of course, SaaS valuations for market leaders have been exceptionally high, helping fuel the creation of more startups. Only, there are a number of SaaS startups that have raised angel rounds but don’t have enough traction to raise a Series A round. This is also related to the Series A crunch whereby the number of VCs has gone down while the number of angel investors has gone up, resulting in a lower percentage of angel-backed startups raising money from VCs.

    Let’s look at an example scenario:

    • Startup raised $500,000 from angels
    • Spent 18 months and burned all the cash
    • Generates $100,000 in annual recurring revenue from 50 customers
    • Added $50,000 in annual recurring revenue in the last 90 days
    • Needs $30,000/month to break even

    This is a tough, common situation. It’s clear that there’s a decent level of product / market fit with 50 paying customers. Yet, only $100,000 in annual recurring revenue, making it far from having a repeatable customer acquisition machine. The good news is that by adding $50,000 in new annual recurring revenue in the last 90 days, assuming no churn, in another 12 months the startup will be break even a $300,000 run rate. So, one way to look at it would be how to get a $200,000 bridge loan to get to break even and have time to figure out how to accelerate growth so as to raise a Series A round.

    For startups that have raised a seed round and are having difficulty raising a Series A round, the most important thing is figuring out how to grow revenue quickly and paint a picture of how putting in $1 of investment yields revenue growth of $1+ (again, assuming almost all recurring revenue and high renewal rates). If there’s no growth story and no customer acquisition machine, investors aren’t going to get excited about investing.

    SaaS startup funding with limited traction is hard, and it’s especially difficult between an angel round and a Series A. As Guy Kawasaki says, sales solves all problems.

    What else? What are some other thoughts on SaaS startup funding between an angel round and a Series A?

  • SaaS Valuation Drivers

    When thinking of Software-as-a-Service (SaaS), one of the first things that comes to mind is the quality of the business model. With almost all recurring revenue, high gross margins, great renewal rates (ideally), and strong market adoption, it really is one of the best models across all types of business. Due to the confluence of factors like quality of business model, hype in domestic public equities, and desire for growth, SaaS companies are currently receiving extraordinary valuations. While I don’t believe 10x+ revenue valuations are sustainable, I do believe we’ll see 4 – 6x revenue valuations indefinitely, assuming 30%+ revenue growth rates (otherwise valuations will quickly drop to 2 – 3x revenue).

    Here are a few valuation drivers for SaaS companies:

    • Growth Rate – this is the most important factor and I calculated growth rate to be a 2.5x multiplier for valuation
    • Market Opportunity – the bigger the better (one of the reasons Workday – NYSE:WDAY – gets such a big premium, in addition to growth rate)
    • Up-sell / Cross-sell Potential – the more complementary the better (one of the reasons Pardot was so valuable to ExactTarget / Salesforce.com)
    • Scale – hitting $10M in revenue really opens things up for larger acquirers and hitting $50M+ in revenue opens things up for an IPO (more options creates more leverage)
    • Renewal Rates – 90%+ is the target (some have greater than 100% revenue renewals because they expand the account size in existing customer accounts), but watch out for leaky buckets
    • Gross Margins – 80%+ is desirable but some SaaS companies have weaker gross margins due to more services work, unusually high on-boarding costs, or other expenses (e.g. third-party fees or licenses)

    SaaS startups, like all companies, should optimize for the needs of the customer and not maximum valuation, but it’s useful to keep these in mind when building the business.

    What else? What are some other valuation drivers for SaaS startups?

  • Credit Lines for Software-as-a-Service Startups

    Now that Software-as-a-Service (SaaS) is mainstream and seemingly billion dollar acquisitions occur on a monthly basis (see Responsys to be acquired by Oracle for $1.5 billion from last week), it’s important to discuss the line of credit options available for these types of businesses. See, most entrepreneurs won’t qualify for a line of credit unless they have personal assets to guarantee the loan (e.g. if you want to borrow $100,000 be prepared to have $80,000 in deposits, real estate, etc. to put up as collateral). SaaS, due to recurring revenue, high gross margin, and the predictable nature of the model makes for a unique business that’s well suited to loaning money based on recurring revenue (even absent free cash flow).

    Here are a few thoughts on credit lines for SaaS startups:

    • Credit lines are often based on a multiple of monthly recurring revenue (e.g. 3x) and annualized renewal rate (e.g. 80%) — an example is doing $500k/month in recurring revenue ($6 million annual run rate) with an 80% renewal rate results in a line of credit of $1.5 million * .8 = $1.2 million
    • Covenants are always required, typically around customer renewal rates (e.g. 70%+ annually), growth rates (20%+ annually), gross margins (70%+), and cash collected over the past 90 days (70% of the line of credit)
    • Banks and other lenders want some level of scale to do a deal (e.g. must qualify for at least a $500,000 line of credit as they don’t want to do smaller lines due to the lender’s business model)
    • Square 1 Bank and Silicon Valley Bank both have great programs for SaaS companies
    • Firms like SaaS Capital are emerging that offer smaller lines of credit as well as lines that aren’t as restricted as banks (but have a correspondingly higher interest rate)

    Pardot was a major beneficiary of a credit line from Silicon Valley Bank and it allowed us to significantly invest ahead of growth. Once a SaaS startup achieves enough scale to qualify for a line of credit, it’s one of the best ways to finance the business.

    What else? What are some other thoughts on credit lines for Software-as-a-Service startups?