Do you know the difference between Market Cap and Enterprise Value (EV)? Market Cap is the value of a company’s common stock (# of shares outstanding X share price). If you wanted to acquire a company it could cost more or less than its Market Cap. Enterprise Value is a metric that describes the total cost to acquire a company. It is a combination of the value of common stock, preferred stock, cash, and debt. Determining the Enterprise Value of a public company is easy — most stock reporting services do it automatically. Calculating the Enterprise Value of a private company is a lot harder.
Enterprise value is perhaps the most common metric used to describe the value of a company. The formula for enterprise value is straightforward:
Enterprise Value Formula=
+ common equity at market value (this line item is also known as “market cap”)
+ debt at market value (here debt refers to interest-bearing liabilities, both long-term three-step and short-term)
– cash and cash equivalents
+ minority interest at market value, if any
+ preferred equity at market value (preferred shares/liquidation preferences)
+ unfunded pension liabilities and other debt-deemed provisions
– value of associate companies
Most major stock reporting services will calculate Enterprise Value automatically for public companies. Here is Google (Alphabet)’s enterprise value I typically use Yahoo Finance’s key statistic feature to find the enterprise value of public companies.
Enterprise Value is different than a stock’s market capitalization. Market cap is the value of a company’s equity or stock. Market cap only addresses a part of the value of a company. It is equal to the number of outstanding shares multiplied by the current share price. While Google’s market cap is 1.8 trillion, its’ enterprise value is $1.78 trillion since they carry $28.1 billion in debt and they have $135 billion in cash.
Market Cap, cash, and debt are the most common metrics in Enterprise Value. The other components (preferred equity, minority interests, unfunded pension liabilities, value of associate companies) occur, but not as frequently.
Enterprise Value is the primary metric used to describe the value of a tech company. Valuations are often expressed using ratios such as Enterprise Value/Revenue or Enterprise Value/EBITDA.
There is a three-step process for estimating the Enterprise Value of a private company:
Many free resources offer revenue information for private tech companies’ revenues. The absolute accuracy of their data is hard to prove, but they are generally in the ballpark of what the actual revenues are. Two excellent free resources include Owler and Crunchbase. Both offer free subscriptions. They provide a plethora of other competitive information. Check out Crunchbase’s profile of Infusionsoft – a marketing automation provider. Here is Owler’s overview of Infusionsoft. You can learn about VC fundraising history, website traffic analysis, ad keywords, headcount, acquisitions, and competitors. I also use LinkedIn’s paid service, Sales Navigator, to learn about headcount by department, recent hires, promotions, etc.
If none of these approaches work for you, it is possible to estimate private company revenues using a headcount proxy. Companies that are in the same industry tend to have similar ratios of revenue/headcount and operating income/headcount. You can examine the filings of public companies to determine a range of ratios. In every 10-K Annual Report, there is a section that lists the total number of employees. Divide that into the reported revenue to get the revenue/headcount ratio. Consider the following table:
To estimate the revenue for the private company you are interested in, find the total employee count (LinkedIn, Owler, or Crunchbase) and apply the Revenue/Headcount ratio from your analysis of public companies’ examples of their peers. You can use the same ratios for private competitors reported by Owler or Crunchbase. Consider this table for marketing automation providers:
There are three methods for estimating EV/Revenue Multiples. They include public company comps, fairness opinions, and industry analyst reports. Industry analyst reports being the easiest to use.
If there are public companies in your industry you can use them to determine average EV/Revenue multiples. Consider the following table:
These are some metrics from public companies in the supply chain management space. When referencing public companies, your private company will usually be valued at a discount. Public companies have annual audits by independent accountants, have to comply with Sarbanes Oxley, and other regulations like the Foreign Corrupt Practices Act. Also, a public company’s equity is liquid — you can buy and sell it on stock exchanges. Private companies can’t do that. The size and revenues are also different. If your firm is $35 million in the size you cannot expect to command the same valuation as a Google or SAP. Typically the enterprise private firms are discounted by 30% to 40% in comparison to public companies.
When a public company is acquired their board of directors is required to get a fairness opinion. A fairness opinion is a professional evaluation by an investment bank as to whether the terms of the acquisition are fair. You can often find fairness opinions in the definitive proxy statements associated with the merger.
For example, here are some excerpts from a fairness opinion associated with the acquisition of Cayenne Software that I played a major role in 1999.
Precedent Transactions Analysis. AH&H analyzed publicly available information for selected, completed transactions (i.e., mergers and acquisitions) involving financially distressed target companies from a variety of industry segments (i.e., Precedent Transactions). The Precedent Transactions reviewed were, in order of date announced: (i) Visigenic Software, Inc. / Borland International, Inc. (Inprise); (ii) Individual, Inc. / Desktop Data, Inc. (NewsEDGE); (iii) CompuRAD, Inc. / Lumisys, Inc.; (iv) NetFrame Systems, Inc. / Micron Electronics, Inc.; (v) Imex Medical Systems, Inc. / Nicolet Biomedical, Inc.; (vi) Somatix Therapy Corporation / Cell Genesys, Inc.; (vii) Compression Labs, Inc. / VTEL Corporation; and (viii) Altai, Inc. / PLATINUM technology, inc. In examining the Precedent Transactions, AH&H assessed certain financial characteristics of the acquired company relative to the consideration offered. AH&H reviewed the value of the consideration paid (the “Transaction Value”) in the Precedent Transactions as a multiple of LTM revenues, LTM operating income, and LTM net income, and as a multiple of the book value of common stockholder’s equity. In addition, AH&H reviewed the premiums/discounts of the offer prices to the closing stock prices one day, one week, and four weeks prior to the announcement date of the Precedent Transactions.https://www.sec.gov/Archives/edgar/data/880229/0000930661-98-001995.txt
Unfortunately, you may not be able to find some fairness opinions that are relevant to your specific situation. Fairness opinions are paid for by the acquired company to justify the actions of the board of directors to the shareholders. It is rare for a firm to determine that an acquisition price was unfair.
Industry analyst reports are the easiest and fastest way to find valuation multiple information. One of my favorite sources for technology companies is the Software Equity Group (SEG). Allen Cinzori and his team publish quarterly and annual reports on the state of M&A and valuations in the technology space. They also are pretty good investment bankers as well. Here is a link to their research reports.
Below is a snippet from their most recent report:
You can use the relative EV/TTM revenue multiples as a rough guide to estimate the value of a private company. Use your estimate of the company’s revenues, apply the industry median multiple, then discount the result like you would for a private company.
You cannot apply the EV/Revenue multiples of public companies to private companies. Private companies are valued at a discount to public companies for many reasons:
- Public company revenues are often significantly higher than private companies
- A private company’s stock or equity is not liquid. Public company stock can be bought and sold every day with transparent pricing
- Public companies’ financial records are audited annually. Many private companies are not.
- Public companies have to comply with transparency regulations like Sarbanes Oxley (SOX). Most private companies do not go through the formal CEO/CFO SOX section 404 certification.
There are 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 a 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 the 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 the scale of total revenue. Investors like to see startups execute a “Triple-Triple-Double-Double-Double”. Once 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 ongoing 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.
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.As a result, private companies are valued at anywhere from a 10% to 50% discount to public companies. There are many factors that impact a private company’s valuation. Check out Why are Private SaaS Companies Valued Less Than Public Peers? For details on the seven factors that impact a private company’s valuation.
Enterprise Value is a useful metric in assessing the value of a company. At the end of the day, however, company value is determined by what a willing buyer is willing to pay in the current market. External factors such as where public markets are at a point in time, and the availability of debt to finance transactions can have a significant influence on the value of a company aside from revenues and profitability. To calculate the Enterprise Value of a private company you need to 1) estimate revenues 2) estimate the EV/Revenue multiple and 3) Discount the private company valuation.
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Also published on Medium.