Internet, mobile phones and cloud computing have arguably been the three most important factors that have driven the world markets over the last decade – a role that was traditionally reserved for primary sectors like oil, banking, agriculture, and healthcare.
Software businesses or to use the right buzzword “software as a service” (SAAS) businesses have become market darlings attracting a large pool of capital across most major markets in the world at (often) seemingly insane valuations. As an outside observer, it may seem that the traditional earnings-based valuation methods are simply ignored by the investors that pay multiples of 5-10+ times revenue (or recurring revenue). Having worked as a valuation practitioner during these times, I can confidently say that this is not the case. While the reported revenue multiples on market transactions can fall within a wide range, as a software business owner looking to raise capital or sell the business it is important to understand why.
The below example provides some context as to what these seemingly high revenue multiples could really mean.
Case Study – venture capital investment in a high growth SAAS business
Company A is a B2B SAAS business, offering solutions to the financial services industry. The Company announced a $10 million investment in the business by a leading venture capital firm, representing a pre-money valuation of $25 million. In a separate press release a few months ago the Company had shared its results for the previous financial year with revenue of $2.5 million. Putting the two together the headline in a financial journal read:
“Venture capital firm pays 10 times revenue for Company A”
Well, not really. Besides the fact that the investor’s valuation was based on a discounted cash flow model (DCF) that took into account revenue increasing manifolds, the Company had completed major customer deployments since the end of last financial year with revenue reaching $5 million for last twelve months (LTM). The annual recurring revenue (ARR) was already at $7.5 million based on contracted customer base. Adjusting for the latest numbers implied LTM revenue multiple of 5 times and an ARR revenue multiple of 3.3 times. ARR of $7.5 million and a normalised margin of 40% (excluding customer acquisition and software enhancement costs) implied a normalised recurring EBITDA of $3 million. The pre-money valuation of $25 million implied a recurring EBITDA multiple of 8.3 times.
Furthermore, the investor was issued a separate class of shares with liquidity preference over existing shareholders that provided significant downside protection to the investor if the business failed to hit the forecast growth. In other words, if the business sold at a valuation of $10 million or less, the entire proceeds would go to the new investor. In the downside scenario tested by the investor, there was an option to restructure its operating cost base to a target EBITDA margin (which was considered reasonable based on the existing product and revenue base). The business would be sold after three years for a modest 3 times EBITDA multiple. While this implied a negative current valuation on a DCF basis, it provided a small positive return to the investor on exit with existing owners receiving a negligible amount from proceeds.
The $10 million liquidity preference implied 2 times LTM revenue, 1.3 times ARR and 3.3 times normalised recurring EBITDA. I typically look at these as “risk adjusted metrics” that the investor is buying into with a massive upside – i.e. if the business does hit the forecast the investor’s capital generates over five times return in around 4-5 years.
So what’s my software business really worth?
As a rule of thumb, investors in small but mature private businesses are typically looking for returns of 15-25%. For businesses that have limited fixed asset requirements (i.e. negligible depreciation) and are growing at inflationary rates of 2-5%, these roughly translate into EBITDA multiples ranging from 3-6 times. Investors in most mature software businesses will have similar expectations. However, if you are a high growth SAAS business the metrics change completely.
Where your business falls within the value spectrum is driven by the following key characteristics:
- Growth – high growth businesses will typically be valued by investors using other methods like DCF. These businesses may not be profitable or may be reinvesting profits into further development and an earnings multiple based valuation may not even be applicable. It is imperative for such businesses to start developing robust forecast models that can quickly demonstrate the impact of changes in key value drivers to potential investors.
- Margins – investors value the ability to maintain margins especially through low maintenance or enhancement costs needed to maintain the existing customer or revenue base.
- Customer concentration – higher concentration of revenue from a small number of key customers will decrease the multiple paid while a well-diversified customer base adds value.
- Customer stickiness – investors value low customer attrition which can be achieved through long term contracts or via deep integration of the software within customers’ key business processes.
- Quality of management team / key person risk – ability of management team to run the business in owner’s absence adds value while dependence on the owner or another key person detracts value.
- Ability to compete – most legacy software businesses face competition from new entrants that are often providing cloud-based SAAS offerings. Ability of the business to evolve and remain competitive is a key investor consideration to preserve future value.
Despite COVID 19, there has been plenty of private capital seeking investments in software businesses in Australia with valuation metrics largely unchanged given strong longer-term fundamentals for the sector. If you are looking to sell your software business, speak to one of our valuation and financial modelling experts. A good understanding of value and key value drivers before starting a business sale or capital raising process will set the expectations right for you and your advisors. We can also help you understand the areas you can strengthen to enhance value ahead of an exit.
 The case study has been adapted from several real-life examples with context and numbers modified to preserve client confidentiality.