Valuations for publicly traded SaaS businesses are bananas right now. At the time of this post, Zoom’s enterprise value relative to its last twelve months of revenue (EV / LTM) was an eye-popping 58.41x. Veeva’s EV / LTM ratio was 37.02x; and “lowly” Salesforce’s was 10.03x. And it’s not just the stock market; valuations for privately owned SaaS businesses are also flying high. Against this backdrop, a colleague recently shared with me commentary from a similarly frothy time for software businesses. In mid-2011, legendary venture capitalist Bill Gurley tackled the topic of business valuations in his Above the Crowd blog with this article: “All Revenue is Not Created Equal: The Keys to the 10X Revenue Club” (5/24/11).
In this piece, Gurley makes a compelling case against the use of revenue multiples as a means for valuing businesses (“…the crudest valuation tool of them all”). But, seemingly acknowledging the ubiquity and simplicity of revenue multiples relative to his favored Discounted Cash Flow analysis, he then goes on to comprehensively explain the characteristics of high-quality revenue companies versus low-quality revenue companies. These differences, he argues, are what accounts for high valuations (10x+) for some companies, and not for many others. In some ways, the article offers a fun look-back to a seemingly quainter time (e.g. LinkedIn had just gone public that week in 2011, and analysts were skeptically scrutinizing its implied multiple of 11.8x — 15x forward revenues). But it is also a timeless study, with many insights that remain applicable today. With that in mind, below is a quick re-cap of Gurley’s Top 10 business characteristics for gaining entry into the “10x Club,” along with some added thoughts about how these apply today within Lock 8 Partners’ core focus area of small-scale SaaS businesses:
1) Sustainable Competitive Advantage: This is a question of barriers to entry or “moats” as Warren Buffet famously described them. Gurley references Coca-Cola for its deep moat (sophisticated distribution channels, global brand, secret recipe) relative to that of RIM (fleeting and difficult-to-maintain tech advantage). Given their small size and relative immaturity, early-stage SaaS businesses tend not to have well-established barriers to entry. Feature sets, ease of use, and customer service are often cited by operators as competitive barriers, but those are (at best) shallow moats. A notable exception, in our minds, is deep domain knowledge or subject matter expertise in vertical SaaS plays. Additionally, SaaS businesses that provide workflow automation become so embedded in their customers core processes, it’s difficult to imagine the business operating without them. In combination, these tend to be hard to replicate, particularly when used to cultivate an active community of loyal advocates (more on that below).
2) Presence of Network Effects: Per Gurley, “In a system where the value to the incremental customer is a direct function of the customers already in the system, you have a powerful dynamic that tips towards winner take all.” In other words, it’s the customer base, stupid! We’ve seen this for years with social networks and telecommunications networks, where the addition of an incremental user makes the network more valuable to all other users . The company that seems to have nailed this recently is Peloton (currently trading at 29.18x revenue). Competitors can certainly manufacture sophisticated exercise equipment but replicating / combatting Peloton’s loyal, networked community is going to be a tall order. A less traditional network effect can show up in small-scall B2B SaaS businesses when a solution emerges as an industry standard within a vertical market, and administrators start self-identifying and touting their expertise in that solution. We saw this in the early days of both Blackboard and BoardEffect; we knew we were going to be tough to beat when people started connecting the brands to their job descriptions on LinkedIn.
3) Visible Predictability: The world has evolved quite a lot since 2011; and the benefits of SaaS subscription models that Gurley describes in detail are now well understood, de facto standards. In our minds, the predictability of a SaaS subscription model is its most important and valuable attribute. Irrespective of whatever else goes on in a business, if it maintains a gross dollar retention rate of 95%+, it has a rock-solid foundation on which to build. With high renewals: investments in the future can be confidently made, slow-growth years can be endured, and hiring mistakes can be overcome. And while there is a lot of justified attention on Net Revenue Retention these days, we still prize high gross dollar retention above virtually anything else when evaluating a business.
4) Customer Lock-in / Switching Costs: This is about lowering customer churn; and it is inversely related to the prior point (retention). Businesses with low churn have higher customer lifetime values, and they are rewarded with higher company valuations. As Gurley points out, “Switching costs can take many forms — technical lock-in, data lock-in, high startup costs with a new vendor, and downstream revenue dependencies are just a few.” We’ve observed that such lock-in can either be voluntary (“why would we ever want to leave vendor X?!”) or involuntary (“we’d love to switch, but it’d be too painful.”). And since small-scale SaaS businesses simply don’t have tons of market power, their stickiness is far better and more sustainable when based on loyalty versus “hostage taking.” This can be assessed through customer calls, Net Promoter Scores, and social media sentiment. Although a bit contrarian, we value voluntary loyalty-based switching costs far more than technical or data lock-in.
5) Gross Margin Levels: Gurley nails this one head on: “…You cannot generate much cash from a revenue stream that is saddled with large, variable costs.” Because of their low marginal costs (more on this to follow), SaaS businesses tend to be blessed with attractively high gross margins. But not always. Particularly in smaller, bootstrapped SaaS businesses, management teams will try to complement their software revenue with a services component, implementation revenue, or embedded third-party products — all of which tend to have lower than average gross margins (versus pure SaaS product revenue). Furthermore, gross margins can be easily overstated in smaller businesses, as management teams sometimes don’t properly allocate personnel expenses (often accidentally); and we’ve learned that this is an area worthy of close examination when assessing small-scale SaaS businesses.
6) Marginal Profitability: According to “The 10x Club” marginal profitability is when, “all things being equal, higher revenues create higher profit margins.” This is also sometimes referred to as “flow through.” Positive flow-through is a benefit of scale, and SaaS businesses typically do well in this regard. Why? Because each new unit from selling existing software to a second customer (or third, or 1,000th) introduces very little in terms of new, incremental expense. As small-scale SaaS businesses prioritize growth, profitability will certainly decline, but incremental expenses tend to be concentrated in sales and marketing (not COGS, per the point on Gross Margin above). As a result, its easy to see where even small-scale SaaS businesses can achieve positive flow-through as they begin to scale.
7) Customer Concentration: Given the importance of visible predictability (Point 3), “all things being equal, you would rather have a highly fragmented customer base versus a highly concentrated one.” This is almost a matter of course in big, publicly traded companies — it’s hard to get too terribly big without a diverse customer base. But countless small-scale businesses are sustained by a few large anchor clients. Such concentration makes any investor nervous. Ideally in our minds, no customer accounts for more than 2.5% of revenue, so the pain of any customer drop is minimal. Lowering that bar to a real-world standard, we prefer that the top 10 customers in aggregate account for less than 25% of a business’ top-line. Beyond that, the higher it is, the scarier it gets. For bootstrapped businesses, it is also worth comparing annual free cash-flow against the revenue from a cohort of top customers. If losing any of those top customers would result in a cash shortfall, it’s likely time to further diversify the customer base or manage spend until doing so becomes possible.
8) Major Partner Deficiencies: “Investors will discount the price/revenue valuation of any company that is heavily dependent on another partner in some way or form.” There is often a great deal of tenuousness among businesses that overwhelmingly base their model on behemoths such as Google, Facebook, Microsoft, Salesforce, and others. As Gurley points out: “No one wants a partner policy or algorithm change to have unpredicted negative impacts on a public company. These risks are accounted for with lower valuation multiples.” This risk is even more pronounced among small-scale businesses that have virtually no influence over their larger partners; and we are admittedly skittish about such situations.
9) Organic Demand versus Heavy Marketing Spend: “All things being equal, a heavy reliance on marketing spend will hurt your valuation multiple.” Interestingly, Gurley’s article doesn’t mention the word “viral,” but today’s readers will recognize this description of companies that grow even without heavy marketing spend. This concept has even evolved into a popular KPI (Viral Coefficient) that measures the average number of new users an existing user generates. Calendly is a current solution that seems to have truly nailed this — admittedly, I signed-up to pay for my own account after the very first time I saw someone else use it. Although virality tends to play less of a role in B2B SaaS (particularly at the enterprise level), word of mouth marketing still exists, particularly in vertical markets. We look for segments where prospective customers do not necessarily compete with one another (i.e. in healthcare, non-profits, education, and local governments) and are willing to collaborate with peers from other organizations. Client references abound in these segments; and those remain the cheapest and best marketing a company could ever hope for.
10) Growth: “Nothing contributes to a higher valuation multiple like good ole’ growth.” Unless that growth is accompanied by sustained losses, which Gurley explains with valuable nuance. In recent years, the Rule of 40, has made this concept even easier to grasp. In short, this establishes a benchmark whereby the combined (A) growth rate + (B) profit margins should exceed 40% among top-performing companies. Some extremely discerning growth investors have even raised the bar to the Rule of 60% or higher. The message is clear: businesses should balance growth with profitability. Unless, of course, a business is growing astonishingly fast; in which case, it can also be wildly unprofitable, still exceed the Rule of 40, and remain a hot commodity (at least until growth cruelly begins to slow).
Managing this 10X Scorecard can seem daunting; many of the components are interdependent. And in small-scale, resource-constrained SaaS business, the tyranny of the urgent can overwhelm even the best laid plans. While year-end brings the customary focus on the planning for the New Year, aligning those plans with your equity value aspirations is good discipline. Because, regardless of whether you’re doing $1M or $10B of revenue — and regardless of whether it is 2011 or 2021 — the characteristics of what makes a quality business remain broadly the same: sticky product, competitive moat, high gross margins, and bankable counterparties are critical for long-term success…and the market will value your business at its discretion.