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Some thoughts on valuing SaaS companies

When I worked in venture capital, I was lucky enough to have the opportunity to invest in some really great companies during their early rounds.  Now some of those companies are going public, and I find myself spending some time thinking about when to sell my stock in these companies.

I don’t think anyone has truly figured out the formula to value these companies.  There just aren’t enough examples of SaaS companies that have reached maturity and shown us what they really look like in the long term.  Salesforce still grows at 23% annually and trades at over 100x EBITDA!

Nonetheless, I thought it’d be an honest exercise for me to write some thoughts down and then review them in a few years.

I think that growth should be the number one factor in considering SaaS valuations (when I say valuation, I mean how much is the company worth on a revenue/gross profit/EBITDA/FCF multiple basis).  If a company can grow at 50% for 3 years, it’s topline will be nearly 3.4x higher!  That’s powerful.

If you’re a real SaaS company, this means you have 80+% gross margins and should start seeing nearly 40 cents/dollar of new revenue start to fall down to operating cash flows.  Assuming the company that grows at 50% annually was cash flow breakeven, that means your operating cash flow in three years is more than your current revenues.

No two companies are the same.  The top factors that would effect valuation are how scalable growth is (sales/marketing channels and economics), how long growth can go for (market size, competition), churn (and how it contributes to growth), and margin profile (gross and net), barriers to entry (that will protect current revenues and make sure new competition doesn’t chip into existing growth prospects)…there are some other things pretty important too, like management’s incentive system.

I think what a lot of investors have figured out is that if a company keeps growing, you can pay through the nose (relative to what most companies trade at) and still make a nice IRR.  I agree that growth is the most important aspect of valuation, and that most of the other factors are basically contributors to growth.  Even in these heady times of crazy valuations, I’d say that a lot of the public companies are undervalued!   The other main factor here is the margin profile.  If you can’t ever be profitable, then forget it.  And, in the case SaaS companies, it’s more like you have to be VERY profitable.

I don’t have time to look up various rules on making stock predictions for companies you own.  So, I’ll leave you with this very basic spreadsheet (SaaS valuations thoughts) that should illustrate that growth is key in valuation and how I think various companies should be valued (although I guess the numbers in blue are very much up to interpretation in most companies).  Enjoy.

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Working in venture capital

A year ago, I started business school at HBS. Since then, I’ve been talking to a lot of classmates about my experience working in venture capital. I thought it’d be useful to share the highlights of some of those conversations for other people interested in landing a job in venture capital. As a disclaimer, what follows is highly colored by my experience as a pre-MBA sourcing analyst at Bessemer Venture Partners.

There are two main roles for junior people at venture capital firms. You are either focused on sourcing new investment opportunities, or supporting more senior professionals in screening their inbound deal flow, executing transactions, and helping existing portfolio companies. I’ll focus on the sourcing role as that’s what I know best.

Sourcing involves splitting time between researching interesting areas of innovation where there may be hidden gems (great companies that people don’t know about yet, typically outside of hot sectors and geographies. Think enterprise SaaS based in Nebraska and focused on dog food manufacturers, as opposed to consumer internet in silicon valley). You may read a blog post about the Turkish eCommerce market, and develop a list of the best companies there. Or, you may hear a lot of buzz about a silicon valley company that is “crushing it.” Chances are, you can find a company in Virginia, or Berlin, or Sao Paolo that is doing the same thing and a lot further along, that no one knows about yet. Or, maybe you meet a really dynamic entrepreneur at a party who just happens to be raising a round. There are lots of ways to find great companies!

Beyond research, you’re also spending time getting to know companies either through meeting in person, or talking to entrepreneurs over the phone in hopes of building a relationship, and understanding where an opportunity to invest in the firm is. Having 4-5 one on one conversations each day is an amazing way to grow your network, develop pattern recognition, and learn about all the areas of innovation around the globe. It’s an addicting flow of information, and comes with insights into how companies succeed in changing markets.

At the beginning of each week, expect to pitch 2-5 of your best ideas to your firm’s partners. In an interesting twist, you are now an agent of sorts for the entrepreneurs you’ve talked to the previous week, trying to get your colleagues’ interest in follow up meetings. Of course, while every sourcer is incented to drum up interest for your deals (typically there is a bonus if a deal you sourced is invested in), you have to maintain objectivity in order to gain credibility within your firm, and grow as an investor.

It’s an incredibly entrepreneurial job where you are constantly trying to figure out new ways to source deals, determine which are the best companies, and then get internal buy-in for a deal. The last part of the job is the diligence of new investments including some light modeling, writing up investment memos for internal use, talking to customers, and doing anything else needed to make the investment. This is where you work in a small team to dig into a company over the course of a few months to figure out whether it’d be an interesting investment or not.

Overall, it’s very hard to think of a better job. It’s rewarding, fun, and stimulating. It gives you a lot of insight into the bleeding edge of innovation across lots of sectors. And, you literally have to pinch yourself when you’re talking to CEOs all day long. Plus you get to learn from great investors in a culture that is typically 100x better than PE/hedge funds. There’s just one catch, it can be a tough job to land!

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Partial Liquidity in Response to Changes in the Capital Gains Tax Code

Many of the larger companies that I speak to are contemplating partial liquidity in 2010 before any potential changes to the capital gains tax code take effect.

The WSJ did a small article on this in last week’s Weekend Edition and I thought I’d run some numbers to see what makes sense when contemplating this decision (dividend taxes could more than double and it looks like long term capital gains will increase 33%).

The attached excel model (see the link below) should provide a working tool to customize this analysis to your own company.  Basically the decision comes down to taking money that is guaranteed and guaranteed to be taxed at a lower rate OR, letting it ride, continuing to grow the business, and keeping a greater equity stake for a larger liquidity event (M&A or IPO) down the line.

Obviously, if your business has Twitteresque growth, you should hang onto the equity for dear life!  But, especially given the relative stability of today’s markets and the relatively strong multiples deals are getting done at, it is worth exploring taking some “chips off the table” this Fall while still keeping a sizeable equity stake in your business to participate in the upside of an IPO or M&A exit.

Another scenario we’ve run into is non-operating partners who have large equity stakes and who may want to take money off the table now.  Especially in the case where these types of companies do not have a strong venture partner, it can make sense to allow those people to cash out, at least partially, in order to bring in a financial partner to help continue the growth of the business.

Below is the output of an NPV analysis on a very profitable and quickly growing business.  As you can see, taking some money off the table now makes sense given the assumptions of the model.  I highly suggest downloading and playing with the excel (see link below) to customize it to your business.

Some notes: I’ve basically assumed in scenario 1 that you sell 20% of your equity, continue to grow the business and then IPO in year 4 (2014).  In scenario 2, you keep all the equity, and IPO in 2014.  The cash flows in each scenario are discounted in order to take into account time value of money and also the probability of the business hitting a rough patch and not being able to deliver on projections.  In the excel, you may also want to take into account that partial liquidity/growth capital now could lead to the acceleration of your business if you find the right venture partner, and thus scenario 1 would become even more compelling.  Enjoy!

Cap Gain Taxes Analysis [Excel]

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“Plain Vanilla” Angel Structure

It’s the middle of internet week!  I’ve already seen 30+ demos, in addition to Meetup Co-Founder Scott Heiferman smashing an iPad on stage at the tech meetup last night (which was at NYU’ Skirball center).  One theme that has been recurrent is that people are unaware of the structure of angel investments.  So, I thought I’d give a brief overview of one common structure.  Please note there is an excel file you can download at the bottom of the post.  It includes detailed notes and may be helpful to have open as you go through the post.

Many seed stage internet businesses look to angels to help them kickstart their companies through growth capital, as well as expertise.  It seems that many people are confused as to what a typical angel investment might “cost” them in equity.  And, while “a convertible note with a 10% PIK and a 25% discount to the series A” (also known as the “plain vanilla” angel structure) may make sense to some people, I thought I’d break down how to interpret that in case there were any non finance geeks out there who were trying to understand what the terms of an angel investment actually mean.

The Basics

I think it’s easiest to use an example to explain this type of investment.  So, Joe is the founder of Newco which is a website that does some sort of location/game based virtual good (insert other buzz words) service.  Joe needs to raise $500,000 to hire a few developers and a sales person.  Joe finds an angel investor who just happens to have a lot of experience in location/game based virtual good services.  Joe’s investor, let’s call her Ms. Jenna, gives him $500,000 and they use the plain vanilla (read typical) angel structure.

Instead of putting a value on the company now, the investor, will get equity based off of the valuation used in Joe’s Series A round of financing (more on that later).  Presumably, when Joe raises his Series A, he will have a few customers, some revenues, and a much better picture for how his company will actually operate.  His company will therefore be more easily valued.

The PIK

PIK stands for paid in kind.  Ms. Jenna is putting up $500,000, and expects Joe to pay her 10% in interest each year.  But, Joe doesn’t have any cash as he is a pre-revenue startup.  So, instead of paying in cash, Joe is going to take the value of the dollars he would pay Ms. Jenna, and add that to the principal of the investment.

In our example, in the first year, Joe will take the 10% interest payment (worth $500,000 x 10% = $50,000) and add that to the principal of the investment, which will now be $500,000 + $50,000 = $550,000.  In the next year, Joe will be charged 10% on that new principal.  His new interest payment is $550,000 x 10% = $55,000.  And his new principal amount is $550,000 + $55,000 = $605,000.  For those familiar, this is the same concept as a negatively amortizing loan.  Instead of paying interest in cash, it is paid as principal, which is the same as saying it is paid in kind (PIK).

The Equity Part of the Equation

We are going to pretend that Joe had a rough go of it and doesn’t raise his series A for 5 years.  In year 5, the principal value of Ms. Jenna’s investment is now $805,225 (please see attached excel to see the calculations, rows 19 and 20 – we just added the 10% interest in each of the 5 years).  The series A investor gives Joe $1 million dollars at a $4 million post-money valuation meaning that they will get $1 mm/$4 mm = 25% of Newco’s equity.  For the difference in pre vs post money valuations, please see the attached excel cell C14.

We said that the angel investment would be invested at a 25% discount to the series A.  This means that instead of investing at a $4 million valuation, Ms. Jenna’s dollars get put to work at a $4,000,000 x (1-25%) = $3 million valuation.  And, her $500,000 originally invested has grown to $805,225 due to the interest which has been paid in kind.  So, her ownership in the company will be $805,225/$3,000,000 = 27%.

At the risk of complicating things, it is worth noting that Ms. Jenna’s original angel investment can also come with a valuation cap, meaning that there is a maximum value that her dollars can be put to work at.  In the excel, I have put this at $10,000,000 so it doesn’t come into play.  But, if Joe’s company was worth $20,000,000 in 5 years when he raised his series A, Ms. Jenna’s equity would be calculated using a valuation of $10,000,000, not the typical 25% discount we have used in our example.  You can see how this benefits the angel investor in the case that they company does take off.  Ms. Jenna will invest her money at a $10,000,000 valuation as opposed to a $ 15,000,000 valuation ($20,000,000 x (1-25%) = $15,000,000)  which would give her a larger equity stake in the company.

End Result

Joe has now raised $1.5 million and is hopefully well on his way to a successful career at the helm of Newco.  He has given up 25% to his series A investors, and 27% to his angel investor Ms. Jenna, and so retains 48% for himself and the rest of his team.

The attached excel sheet has all of these calculations and is set up in a way that you can play around with different assumptions.  Please feel free to email me with any questions! phil (at) philstrazzulla (dot) com.  Also, please note that this is meant to be an overview of one type of common angel structure and that there are definitely more out there.   Enjoy!

The Excel: Angel Investing Basics