I talk with SaaS companies that are looking to buy other SaaS companies or sell their own each month. For the past year their comments have been the same. The buyers lament the high valuations sellers expect, and sellers, especially private companies, bemoan the low valuations they are offered. They want to know why private SaaS companies are valued less than their public company peers?
The Software Equity Group publishes monthly, quarterly, and annual research on SaaS M&A tranactions. Recent reports show the Median Enterprise Value/Revenue ratios have been skyrocketing:
There is significant variance of EV/Revenue based on the market a firm is in:
It is important note that these are all public firms. The majority of the privately owned firms I consult with report that they are receiving valuations 4o% to 60% less than the median EV/Revenue for firms in their market segment.
Valuing private companies is tough. There is limited to no audited financial information available. A potential investor must rely on their own diligence. Most investors have their own valuation models that emphasize items that are important to them. There are some common factors that most investors utilize.
There three major factors that impact private SaaS company valuations and there are six minor factors:
Major Private SaaS Company Discount Factors
- Liquid equity
- Audited Financials
- SOX 404 certifications
Minor Private Company Discount Factors
- Revenue Scale & Growth Rate
- Market Size
- Revenue Retention Rate
- Gross Margin & Revenue Mix
- Customer Acquisition Efficiency
There are three major factors that collectively account for the majority of valuation discounts private SaaS companies face in comparison to their public peers. These factors include:
The single largest factor is that public SaaS company’s stock/equity is traded and priced every business day. The market takes into consideration everything it knows about a company and sets a price. People can buy or sell every day. Privately held SaaS companies equity is not publicly traded. It is only priced when a new round of funding is raised or a private placement is made. Investors impose a steep discount for private versus public companies.
Public companies are required to have their financial statements audited, and an opinion rendered by the auditor.
An unqualified opinion is an independent auditor’s judgment that a company’s financial statements are fairly and appropriately presented, without any identified exceptions, and in compliance with generally accepted accounting principles (GAAP). An unqualified opinion is the most common type of auditor’s report. Like any auditor’s opinion, it does not judge the financial position of the company or interpret financial data. It indicates that as a result of the testing done during the audit, the independent auditor has enough information to conclude that the company’s financial statements conform to GAAP and fairly present the company’s financial position for the statement time frame. It is issued when the auditor believes that all changes, accounting policies and their application and effects, have accurately been disclosed.
A qualified opinion is a statement issued in an auditor’s report that accompanies a company’s audited financial statements. It is an auditor’s opinion that suggests the financial information provided by a company was limited in scope or there was a material issue with regard to the application of generally accepted accounting principles (GAAP)—but one that is not pervasive.
Qualified opinions may also be issued if a company has inadequate disclosures in the footnotes to the financial statements.
Audited financials provide investors with clarity and consistency.
Any privately held SaaS companies do not have their financial statements audited. This can cause problems with investors and potential acquirers. These organizations must conduct their own diligence. Many privately held firms ‘bury’ owner’s expenses in their P&L. Examples include non-business travel expenses, personal legal services, rent/lease payments on non-business related real estate and equipment. I once found that a prospective acquisition candidate had inflated their revenues so that a credit card processor wouldn’t fine them for excessive chargebacks. They used relatives’ credit cards to pay for monthly services that were subsequently refunded to them.
The SOX Act, passed in 2002, affects all companies, regardless of industry. It addresses corporate governance and financial practices with a particular focus on records. SOX includes 11 titles with the primary audit-related sections being 302, 401, 404, 409, and 802. 302 – Requires periodic statutory financial reports. The reports must present an honest accounting of a firm’s financial stability, any fraud incidents, ineffective control methods, and changes/improvements to internal controls.
- 401 – Addresses full financial disclosures, including liabilities, transactions, and accounting practices.
- 404 – Analyzes internal controls and financial reporting procedures.
- 409 – Requires companies to inform the public of changes in financial operations or significant changes in the company’s financial position.
- 802 – Addresses fraudulent documentation (e.g., falsifying records) and consequent penalties
Every time a company makes a public filing containing financial statements the Chief Executive Officer and the Chief Accounting Officer have to personally certify the adequacy of financial controls and the accuracy of financial statements. These certifications are powerful motivation.
Private SaaS companies do not have to make these disclosures and certifications
Each investor/acquirer has their own model for discounting for Illiquid Equity, No Audited Financials, and No SOX 404 certifications. 30% is a common metric used in the SaaS industry.
There are six common minor factors that are applied to private SaaS companies. Usually they are presented in context of the median performance in their market segment. Consider the following:
This is a typical model that investors and acquirers use to assess a potential investment. A multi-factor model like this looks at a company from multiple perspectives. The more fact-based perspectives, the better the results will be. You can download this model here. Cells that are highlighted in yellow can be changed.
Investors place a premium on revenue growth rates and scale of total revenue. Investors like to see startups execute a “Triple-Triple-Double-Double-Double”. One a firm reaches product-market fit and $2 million in ARR they should focus on tripling the revenue to $6M and tripling again to $18M, the execute three years of doubling revenue ($36M, $72M, & $144M). This is the performance of a unicorn. Not every company can be a unicorn – look at the median revenue growth rate in your market and assess how your growth rate stacks up.
The larger the market, the better. Investors are long past the “if we can get 2% of a billion market we’d be great” market sizing. You need to be able to intelligently discuss Total Available Market (TAM), Serviceable Addressable Market (SAM), & Service Obtainable Market (SOM).
Revenue retention is a critical indicator of the health and longevity of a business.
Net dollar retention is a common metric. It measures what percent of revenue you retained from the prior year after accounting for upgrades, downgrades, and churn. Formulaically it’s beginning of period revenue + upgrades — downgrades — churn all divided by beginning of period revenue. If that formula yields a number greater than 100%, then growth from your existing customer base more than offset any losses from that customer base.
Similarly, net retention below 100% means churn and downgrades were greater than any growth you enjoyed from the expansion of existing customers. If that’s the case, you need to take action with Customer Success and Customer Support to try and reverse the trend.
Here is a list of public companies and what their retention rates are like:
The valuation of your firm will depend on how your retention rate compares to the median of your industry.
Gross Margin is a key metric for SaaS companies:
Gross margin is a very important metric Software Equity Group looks at when evaluating a business. Based on our experience, a good benchmark is over 75%. Typically, most privately held SaaS businesses we work with have gross margins in the range of 70% to 85%. Anything below 70% begins to raise a red flag, requiring additional analysis. It is important to note we occasionally see SaaS businesses incorporating on-going services into their business models. While this causes us to look deeper into the company’s scalability, we often see a favorable tradeoff resulting in exceptionally strong gross retention and net retention.
Software Equity Group
Higher than median gross margins are correlated with higher Enterprise Values:
As noted in a white paper by SaaS Capital
Both investors and strategic buyers are typically looking to continue growing a SaaS business by deploying more capital for sales and marketing. How efficiently the business converts that spending into new customers is highly relevant to both projected future cash flows at maturity, and the amount of capital required to get there. Companies with high customer acquisition costs (CAC) need more capital to grow, and thereby, diminish overall returns whether the buyer is a VC, a corporation, or a public stockholder.
There are many ways to measure the CAC ratio, and for this analysis, we will keep it simple:
CAC Ratio = New ARR from new customers ÷ sales and marketing spend to acquire those customers
In English, how much in annual revenue is generated for each dollar invested in sales and marketing?
Our 2019 survey of SaaS companies yielded a median CAC ratio of .78. This means that each dollar of sales and marketing spend generated 78 cents of annual recurring revenue. This can also be thought of as a monthly payback period of 15.4 months (12 months ÷ .78).
It is important for a business to be self-sustaining. Private SaaS firms that are not profitable will take a major valuation discount as investors/acquirers assess how much capital is needed to sustain operations. The median profitability in your industry is a function of how advanced your market is. In early stage markets, profitability is not rewarded – the profits could be reinvested to rive more growth/revenue. In mid-to-late stage markets (Moore’s Early Majority to Laggards) profitability becomes more important.
Valuations of privately held SaaS companies will always be discounted from their public company peers. The major drivers of the discounted valuations are illiquid equity, no audited financials, and no SOX 404 certifications by the CEO and Chief Accounting Officer. There are many minor factors that can impact valuations. These minor factors look at your firm’s metrics in comparison to industry median stats. If your firm performs lower than the industry median, it will take a valuation hit. If it outperforms the industry median, you could be entitle to a premium. In any event, private SaaS company valuations are driven by what potential investors/acquirers consider to be valuable at a specific point in time.
Also published on Medium.