While valuation principles apply to all industries, each industry may have additional considerations and metrics that guide valuations. This article will focus on valuation considerations that are specific to the tech industry; our Valuation article addresses basic principles that should be applied to all industries. As you gain an understanding of important considerations for the technology industry, you will learn where to direct attention to increase your valuation and be better prepared to engage in valuation negotiations with investors. We will address the following unique considerations for the technology industry: the impacts of total addressable market, revenue growth and scale, Software as a Service (SaaS) metrics, retention rates, certain financial ratios, and industry rules of thumb.
Total Addressable Market
Total addressable market (TAM) is a figure used to estimate the entire revenue potential for a company if they had 100 percent market share, and it’s used to approximate value. For example, all else being equal, consider which of the following two companies you would prefer to invest in:
The answer should be clear—Company B has a significant advantage in its growth potential due to its larger market. This potential will heavily influence valuations.
Misunderstanding the potential for a company or market can lead to terrible decisions. For example, when asked about the iPhone in 2007, Steve Ballmer—then CEO of Microsoft—said derisively:
$500? Fully subsidized? With a plan? …That is the most expensive phone in the world. And it doesn’t appeal to business customers because it doesn’t have a keyboard. Which makes it not a very good email machine.
Today, we have the benefit of hindsight to realize that this statement is obviously flawed for numerous reasons. At a deep level, Ballmer misunderstood the size of the market. He thought the entire market for Apple and Microsoft’s smart phones was exclusively business customers and thereby misunderstood the potential. This misunderstanding created bad assumptions and led to bad investment decisions. Estimating the TAM is a complicated and extremely subjective undertaking. For more detailed information, read our Total Addressable Market article. Hiring an experienced professional may be necessary to get an accurate TAM estimate for your company. Properly understanding an industry’s TAM helps companies to capture value.
Revenue Growth and Scale
When valuing a high growth technology company, net income is not as useful as a unit of measurement as it is for other companies. Young companies that are growing quickly are often reinvesting their money as fast or faster than they are making it. This leads to net losses, which makes the typical discounted cash flow (DCF) and market comparable valuation methods ineffective. However, investors still perceive value in these types of companies partly because once growth slows and massive spending decreases, the company could become profitable.1 For example, Pluralsight, SurveyMonkey, and Uber all had negative earnings when announcing their IPOs in 2018-19. Using a DCF with negative earnings or a value multiple on negative cash flow would result in a valuation less than zero, which isn’t useful since investors still perceived value in these companies and were willing to invest.
Since a net loss does not give investors proper information about growth prospects, revenue growth rates have become a more important measure for valuing a tech company. Investors want to look at a company and see reliably high year-over-year growth rates because this offers assurance the company will one day be profitable and earn a healthy return.
Valuation professionals also use revenue multipliers to value tech companies. These multiples of current or next year’s projected revenue provide insights into the company’s total value. The higher and more consistent the revenue growth rate, the higher the revenue multiplier. All else being equal, two companies with the same revenue amount will earn significantly different multipliers if one company has a 40% growth rate and the other 10%. Additionally, valuation professionals give greater weight to growth rates at higher revenue stages. For example, growing a with $500k in revenue by 50% year-over-year is easier than growing a company with $750M by the same percentage. Multiples of forward revenue for a regular company are about 6 to 8 times, and a “supercharged” company are about 12 to 16 times.2 For more information, see our Up-Cs and Other Supercharged IPOs article.
SaaS Company Metrics
For Software as a Service (SaaS) tech companies3, Annual Recurring Revenue (ARR) is often used instead of revenue in valuation. Because SaaS companies sell access to their software on a subscription basis, they create recurring revenue streams that are less expensive to maintain because customers are locked into a contract and lose access to the software if they do not make their payments. Comparatively, the perpetual licensing model has consumers purchase a license that gives them the right to use the current version of the software indefinitely. SaaS companies avoid the costs of convincing customers to upgrade to newer versions of the software. Using this method, a SaaS company can spend heavily to increase ARR—often running at a loss for many years—and then when spending is decreased, the revenue will continue at the same level. This pattern can be quite impactful for a SaaS company. Be aware that, for SaaS companies, revenue is generally recognized over time as the service is provided to the customer. In contrast, the perpetual license model recognizes revenue for license fees immediately once the software is delivered to the customer because the performance obligation has been completed.
Many SaaS companies believe, due to the high-growth nature of the tech industry, that using revenue for valuations does not capture the true state of the company. Rather, SaaS companies want to use the current value of all recurring contracts to more closely approximate value. For example, in 2012, Adobe introduced Adobe Creative Cloud which gave users access to a suite of software for a monthly price. While this change from non-recurring licenses to recurring subscriptions of software caused revenues to fall nearly 35% the following year, Adobe’s stock price almost tripled over the next 4 years.4
Billings growth may also be used as a measure to assess the potential profitability of the company. This metric measures the customer growth rate through the amount of subscriptions billed. This measure was particularly important for Pluralsight during its 2018 supercharged IPO.
Customer Retention Rates
While billings, revenue, and ARR growth rates are important metrics, they are enhanced by knowledge of their sustainability. SaaS company investors pay close attention to retention rates since this serves as a proxy for company sustainability. A retention rate is a measure of the percentage of revenue the company can retain. Customer retention rates are a powerful way of identifying whether customers are being retained long term or quickly leaving after using the technology. If customers are consistently choosing not to renew their contract, no amount of new business growth will compensate, and the company’s valuation will decrease. Retention can be measured in gross or in net. Net retention measures the positive effect of up-selling, price changes, and cross-selling within the customer base, and the negative effect of lost customers. Increasing net retention indicates customers are being upscaled on average. Good net retention rates are often above 120 percent.5 A combination of high billings growth and high retention rates will increase the valuation.
As mentioned earlier in the article, investors still perceive value in technology and SaaS companies even when they are suffering from net losses. Gross margin is one of the metrics investors watch closely to determine if the company is headed toward profitability. This ratio allows investors to see if the costs associated with the services provided to customers are decreasing relative to revenue. As gross margin increases, it is more likely the company is headed toward eventual profitability. For example, Tesla’s 2019 third quarter earnings announcement surprised investors with a quarterly profit by delivering a record number of cars while keeping costs lower than previously expected. Automotive gross margins increased roughly 3.9 percent from the second quarter, which caused Tesla’s stock price on the day of announcement to increase over 20 percent.6
Another metric investors follow is the revenue mix of recurring growth versus one-time sales. For tech companies (and especially for SaaS companies), investors generally want to see evidence of recurring growth more than an increase in one-time sales. These one-time sales, like implementation fees or other professional services, do not tend to be a predictable form of revenue. Although offering professional services as part of a package can be a great way to get customers in the door or to increase retention rates, it doesn’t constitute the main operations of the company. Tech companies experience a greater return by focusing on building out their SaaS platform to generate recurring revenue than they do by extensively developing their professional service offerings. The exact mix of revenue from professional services and recurring software can differ widely based on the specific company, growth stage, and industry. For example, growth SaaS companies with annual recurring revenue in the range of $20 million to $100 million with average contract values from $10 thousand to $50 thousand often have professional services representing 12-18% of revenue.7 Do not neglect professional services in customer acquisition and retention efforts, but generally professional services will represent less than 20% of total revenue in mature SaaS companies.8
Rule of 40 and the Magic Number
SaaS companies often use an industry rule of thumb called The Rule of 40 to gauge the attractiveness of a company. This Rule of 40 number is calculated by adding recurring revenue growth percentage and earnings before interest, taxes, depreciation, and amortization (EBITDA) margin percentage.9
Rule of 40 Number = Year-over-Year Revenue Growth % + EBITDA Margin %
The company is generally more attractive if the Rule of 40 number is above 40%. If the number is below 40%, the rule of thumb says the company may be spending too much cash to grow. The Rule of 40 is more of a guideline than a rule; however, companies that meet or exceed the 40% threshold are in a much better position to receive a favorable valuation. Companies that fall under this threshold are signaling that more effort and investment are required to grow.
The “Magic Number” is a metric increasingly used by Chief Revenue Officers (CRO) to evaluate how efficient and profitable acquiring new customers will be. The Magic Number is calculated by first finding the difference in new customer revenues between the most recent quarters and dividing that by the earlier quarter’s sales and marketing expense. That number is annualized by multiplying by four, which is then evaluated against a benchmark to determine if the company is spending too much to acquire new customers.
[(Q2 Revenue – Q1 Revenue) / Q1 Sales and Marketing Expense] * 4
Common practice and agreement show that a Magic Number over 1 is generally considered to be a desirable business investment and a number above 1.5 is very attractive. Companies with a Magic Number in this range have an efficient go-to-market model and are scalable. Companies with a Magic Number below .5 need improvement in their customer acquisition model before scaling or going public.10
To earn a favorable valuation for your tech company, you will want to start preparing a couple of years in advance. Concentrating on the metrics and measures discussed in this article will assist you in identifying areas to improve to achieve a higher valuation.
- The Wall Street Journal: IPO Market Has Never Been This Forgiving to Money-Losing Firms
- According to valuation professionals involved in Pluralsight’s 2018 supercharged IPO and supported by Crunchbase
- SaaS Companies use a business model of hosting their software on servers and providing customers access over the Internet for a monthly, quarterly, or annual subscription fee. This differs from the traditional model of selling the user a one-time license to download the software with later upgrades requiring an additional purchase.
- Harvard Business Review: How Investors React When Companies Announce They’re Moving to a SaaS Business Model
- 120% net revenue retention is “good” according to valuation professionals involved in Pluralsight’s 2018 supercharged IPO and is supported by SaaS Capital
- Reuters: Tesla’s Difficult Path to Profit in Six Charts
- The Economics of Professional Services for Private SaaS Vendors
- Forbes: SaaS Myths – Great SaaS Companies Don’t Have Professional Services
- The SaaS CFO: How to Apply the Rule of 40 for Your SaaS Company
- A new metric for CMOs: The Magic Growth Number