Source: Tom Tunguz

Why investors are paying 10x revenue for the best software companies

As an ex-banker, paying 10x revenue for non-early stage companies does not make sense at first glance. At a 25% free cash flow margin, that means I am paying 40x FCF. Is it not too expensive? Here’s how I made sense of why public and private investors are willing to pay 10x software for the best software companies from a fundamentals perspective — bridging the gap between multiples and the core finance theory of free cash flows.

Concepts

An investor’s decision depends on the expected return, usually the internal rate of return (IRR), which is determined by the price it pays relative to a company’s future cash flow (FCF). FCF depends on revenue size, free cash flow margins and growth rate. Here is a simple IRR model driven by the variables mentioned: link. Note that the price of the company is dynamically adjusted to revenues since we are calculating price based on revenue multiples.

Modeling

The FCF margins and growth scenarios are modeled after Salesforce, which is still the benchmark for SaaS companies. A ~25% FCF margin is what a good SaaS will have in the long run. Salesforce already had these margins in its earlier days. There are two growth scenarios high growth and mature but growing. The high growth scenario follows the growth trajectory of Salesforce after its IPO at ~$100M in revenue. While the mature scenario assumes the 25% growth rate the Salesforce has been maintaining in recent years.

Why 20 years? I cut off the cash flow projections by year 20 because the average life of an S&P company is 18 years and that it does not move the IRR materially. I projected up to 200 years.

Also, this does not reflect an investor’s cash flow which would just be the price paid today and the exit several years from now. After playing with different exit scenarios, the conclusions remain the same. So I kept the model as is.

Takeaway

In the high growth scenario, the 30% IRR is great considering the top quartile of growth funds return less than 20%. Every growth investor would fund these. In the mature category, representing public SaaS companies, the 15% IRR is great too considering that S&P returns ~10%. Even though 10x sounds like a lot, it makes sense.

So why is the median growth fund return 10%? Its because it is harder to find companies with these best in class metrics (at bats) and that even the best growth funds do not get it 100% right (batting average). Also think of how many software companies are going public but still foresee losing money (negative FCF margins) over the next few years. Bessemer’s Cloud Index shows that the median FCF margin is only 6%. But when an investor believes that a company can get the top tier numbers (e.g. Rule of 40), 10x is a good price.

Also available at kenn.io. Views are my own.

VC and early-stage learner