If you’re a founder at an early stage SaaS startup, you’re always looking for ways to drive higher and higher valuations, especially as you move from one round of funding to the next. At Lighter Capital, we don’t rely on valuations in our financing model, but I thought it would be useful to talk about valuations as they relate to SaaS companies. We’ll take a look at common valuation techniques and discuss drivers that can help you improve your company’s valuation.
Currently, business valuations are determined via two methods:
Discounting future expected metrics like cash flows
Applying a multiple against a company metric like revenue.
Discounted cash flows
First, let’s look at the discounted cash flows method. Using this method, a cash flow positive company can model out future and terminal cash flows based on an assumed growth rate. Then these future cash flows can be “discounted” against an expected market return or ROI, and finally summed up for a current valuation.
In these instances, cash flows are usually based on EBITDA or operating margin adjusted for one-time events and other factors that can obfuscate the company’s underlying historical cash flow generation. Unfortunately, having positive cash flow is a long way off for early-stage SaaS businesses, because they’re continuing to burn in order to grow.
Forward multiple revenues
This brings us to the most commonly used method of valuing young SaaS businesses: forward revenue multiples. If a SaaS company is growing, but showing a net loss, then revenue multiples are the next best consensus method of valuing a SaaS business. Using this method, a multiple (typically somewhere between 4x and 6x per a recent Techcrunch post) is applied to your company’s most recent trailing twelve months of total revenue.
A number of factors can affect the multiple a company receives. This can include things like potential market share and total addressable market size based on the product or service provided. Think CRM software for wet shaving e-tailers (niche) vs something that has a large potential customer base, like a ride-sharing service.
Another factor used to determine a company’s multiple are the multiples assigned to comparable companies—if a competitor sells or IPOs, this can be a good indicator of the expected revenue multiple similar companies would receive.
The last and most relevant factor in determining a company’s multiple is growth rate. The higher the revenue growth rate, the better the multiple a company will typically see on its valuation. This means that a high flyer can usually punch above their weight class in terms of their multiple. Since growth rates are expected to flatten as a company reaches maturity, a compound annual growth rate (CAGR) is often used to smooth out these varying rates. If your company is growing at a faster and faster pace, then you could expect a larger CAGR. Alternatively, if you’ve seen significant growth in the last few years, but that growth rate has started to decay, you may see a lower CAGR used when assigning a revenue multiple to your business.
How to increase your valuation
So what can you do to drive a higher valuation for your SaaS business? Let’s assume your company is small and burning, but you’re seeing steady topline revenue growth. If you’re trying to maximize your multiple, your top priority should be increasing net sales. This may seem like common sense, but as startups move from the development phase to the deployment phase, they sometimes allocate more resources for add-on development, but not sales and marketing. This can cause a great product to languish, because it’s continually tinkered with, but under-deployed.
We’ve seen this happen most commonly with companies that are sitting on a large cash pile, and have no concerns about their burn runway. Such a company may be able to continue to burn for another 12-18 months, but is growing too anemically to maximize their potential revenue valuation. Investing a bit more now to drive sales will likely be better for your valuation than trying to tack on one more month of runway, especially if your funding round closes before the runway disappears.
The current climate in tech investing still feels a bit bubbly, and a lot of people are waiting for a “long winter” in tech capital fundraising. In a down market or an industry-wide bubble bursting situation, Angel investors become more cautious, and they want to reallocate a larger portion of their investment portfolios in safer asset classes while they wait out the storm. So when there’s a flight to safety, these funds dry up pretty quickly. Institutional investors and funds are committed to keep deploying capital as their investment funds are usually geared towards longer holding periods, and they have dedicated pools of capital they need to put to work. So they tend to ride out the storm. When it’s a buyer’s market, choosy investors can negotiate down your multiple.
As noted at the beginning of the post, we don’t rely on valuations when we make funding decisions. Learn more about our revenue-based product, a RevenueLoan, and see how our model works.