The software market continues to evolve.  Historically, enterprise software was typically sold as a one-time, perpetual license plus an annual maintenance payment, usually representing 20% of the cost of the license.  The license revenue was typically large-dollar, but lumpy and non-recurring, and sales cycles were long. That said, a real benefit of the model, particularly for earlier stage companies, was that the cash generated from the sale of licenses could be used to fund the business.

Software-as-a-Service, or SaaS, models, which have become ubiquitous since Salesforce.com’s IPO in 2004, take a different approach.  SaaS is sold as a subscription, often monthly.  SaaS providers aren’t able to take advantage of being paid in advance, but the recurring nature of the revenue makes it easy to budget, and the high “flow down” of revenue to EBITDA beyond the company’s breakeven point makes it very profitable.

The inherent advantages of recurring, predicable revenues and the high “flow down” nature of the models naturally result in valuation differences between the two models, with enterprise software companies typically trading for circa 1 to 3x revenue and SaaS companies trading for 3 to 10x revenue. Further, many SaaS companies trade outside that range, both higher and lower.  So the question is, given the wide range of SaaS multiples in the market, what are the key factors distinguishing higher multiple companies from lower?

We believe that there are several core factors influencing SaaS valuation multiples. Those companies with metrics “to the right” in each of the factors tend to trade at higher valuations. The factors that we pay closest attention to are:

• Annual Recurring Revenue (“ARR”) Growth and Scale. Growth should be analyzed relative to a company’s peer group. Smaller companies are expected to have larger growth rates than larger companies, and larger companies will generally have higher multiples than smaller companies at similar growth rates.
• Rule of 40%. Companies with a combination of growth rate and EBITDA margins of 40% or more will generally command premium valuation multiples. Note that the rule holds true for companies at scale (greater than $8 to $10mm in revenue). For smaller companies, the threshold is generally higher.
• Addressable Market and Moat. Having a unique offering positioning a company as a pioneer and leader in an emerging market segment that has the strong potential of growing to $500 million to $1 billion+ in five to seven years, and a substantial technological lead (two or more years) with a roadmap that maintains future leadership that reduces risk of marginalization and commoditization, strongly positions a company for a premium valuation.
• Gross Margin; High “Flow Down” Model. Gross margins exceeding 70% indicates an attractive mix of software revenue and services. Beyond break-even, true SaaS companies may flow 50% or more of revenue to EBITDA.
• Revenue Retention. A revenue retention rate of 100%+ (growth in revenue from existing clients exceeds revenue lost to churn) is a key indicator of the predictability of future cash flows and a strong indicator of ARR growth.
• Customer Acquisition Cost (“CAC”) Ratio. CAC ratio is a measure of (i) the sales, marketing and other costs to acquire a customer to (ii) the incremental revenue gained during a given period, and a key indicator of the capital required to grow a company. Companies with CAC ratios under 1x have a strong likelihood of receiving a premium valuation providing the aforementioned metrics and characteristics are also solid.

In addition to these six core drivers of valuation multiples for SaaS companies, there are a myriad of company-specific factors that drive premium valuations; these factors are generally “hidden” in the aforementioned “Addressable Market and Moat” and are difficult to benchmark.

Achieving a premium valuation is significantly more difficult than a simple mathematical exercise. Many assume that SaaS companies automatically benefit from viral marketing; this is rare and it takes significant time and investment to scale (four years / $16 mm in equity capital and six years / $25 mm in equity capital to achieve $10 million and $20 million ARR run-rates, respectively). Positioning a company well and developing pressure-tested financial models that highlight a company’s “moat” and ability to grow are essential to achieving premium valuations.