It is common these days to hear or see in the media news of sky high software company valuations. There are often high revenue multiples used to value these businesses. Why does that happen, and how does the market come to those conclusions?
Three things are required to achieve such metrics:
- High rates of growth and low churn
- A large addressable market
- Ideally high gross profit margins
The primary goals for most business owners are profits and cash flows. So, it can seem strange that such huge revenue based valuations are placed on Software-as-a-Service (SaaS) companies, when the majority of them are currently not profitable. However, when you understand the life cycle of SaaS companies, it all starts to make sense.
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Understanding the life cycle of SaaS companies
To understand why SaaS businesses are valued on revenue multiples, you need to understand the typical life cycle of these businesses.
A new software is created which solves a problem or is superior to an existing platform. During this phase all focus is on product development, customer acquisition, customer feedback and iterating the product consistently to improve the offering.
At this stage, the expenses of the business far outweigh the revenues of the business and thus there are negative cash flows.
The software gains traction in the market and revenues grow exponentially. The success of the platform with customers often triggers an acceleration of expansion plans and additional funding is required to accelerate growth through marketing expenses. Additional expenditure may be incurred on hiring sales staff, expanding geographically, or building new modules and functionality in the platform.
The important metrics in this phase of the business are the Customer Acquisition Cost (CAC) and the Life Time Value (LTV).
Essentially, if it costs you $100 to acquire a customer, and $500 of lifetime value, it can be highly valuable for the long term. However, if the LTV is only $150, the customer proposition is marginal.
After years of strong double-digit revenue growth the business may reach maturity in their market, hopefully as the market leader. At this stage the company has substantial revenue but the growth of revenue begins to slow down, whilst the cost base is relatively fixed. At this stage, successful SaaS businesses become ‘cash cows’. To become a ‘cash cow’, SaaS businesses must have the following characteristics:
- Very low customer churn: The investment in acquiring customers is lucrative if they become long term subscribers of the platform. The term “recurring revenue” is often used to describe this. Some of the best SaaS companies even have negative churn, meaning that the revenue increases from existing customers outweighs the revenue lost from churned customers. If churn is high the business will have substantial customer acquisition cost, and this will materially hurt profits.
- High gross profit margin: A good SaaS platform should have high GP margins as there are very few direct costs in providing a digital product. A good SaaS platform will also have low customer service costs as the platform is intuitive and allows customers to resolve any issues on their own.
- High potential growth rates and a large market size: A large international market will drive profits. If a platform is too niche or restricted by a single region, the profitability ceiling will be hit very quickly.
Why are SaaS businesses valued at revenue multiples?
Whilst in the high growth phase it is difficult to value a business on profitability, or EBITDA. Valuers use a combination of the following factors to forecast future company performance:
- Revenue growth
- Gross margins
The theory is that with low customer churn and high gross profit margins, the majority of the revenue should flow through to earnings once the company matures and less investment is required in customer acquisition and platform development.
Revenue multiples are thus the most appropriate metric to value these businesses. Depending on the addressable market and the margins the revenue multiples can range from 2x towards 10x.