We are often asked by start-ups, especially during term sheet negotiations, how we come up with a certain valuation figure? Apart from experience, gut feeling and market drivers, there is also some methodology based on it.
Challenges of venture valuation in general
So what are the problems about venture valuation in general? Correct forecasting! The riskiness of new ventures centers on several characteristics caused by the immaturity of the firm. There is high risk in future revenues (no or little financial history with negative earnings) and lack of an operational track record. A sustainable market acceptance through customers of the product is often not or only partly proven. The product or technology is either not developed and unproven or the level of quality for a mass customer base is still outstanding, which increases technology risk. Moreover, the founding team might not be qualified to build a new company. Lastly, due to a shortage of internal financial means, the new venture is vulnerable to economic crisis and larger competitors.
When looking at dominated company valuation methods from an entrepreneurial finance research perspective, the problem becomes even more obvious. New ventures do not fulfil certain criteria necessary for the application of existing models. Their applications are often difficult due to missing data. For instance, ventures have a short history that complicates the extrapolation of the past into the future necessary to calculate financial forecasts. Lacking this information, the object of research is afflicted with high uncertainty, which results in increased cash flow variance and, thus, in higher total risk. Contrary to the dominant financial market assumption of normally-distributed returns, it has been empirically proven that the returns of young companies follow an asymmetric right skewed curve of distribution. In addition to that, idiosyncratic risk matters for VCs, whereas most models, such as the CAPM only observe systematic risk and assume that investors are perfectly diversified. Thus, it becomes necessary to consider total risk. Last, VCs do not operate in efficient markets, which is one important assumption of several cost of equity models.
Value drivers of B2B SaaS ventures
Having that (scientifically J ) said, it becomes even more difficult to find a valuable valuation approach for B2B SaaS ventures. In a nutshell, I have to conclude that the quote from one of the most recognized and well-known researchers in the field of venture valuation — — Aswath Damodaran “The valuations we arrive at for individual businesses reflect the errors and biases we have built into the process. All too often we find what we want to find rather than the truth.” is very true J . Qualitative risk factors matter!
Research in that area argues that the value of a venture is driven by drivers like market, human capital, exit potential etc.
Nevertheless, it is not that easy to derive a final valuation figure. Moreover, valuation of start-ups is still a very important part of the VC business and most of the time the main topic during term sheet negotiations. So, how do we try to apply existing valuation methods when evaluating B2B SaaS ventures?
There are many approaches to value a SaaS start-up, but the most common one is applying a revenue multiple. We take the last monthly MRR of the venture and multiple it by 12. So we get the annual revenue run rate. With mature companies, you take the comparable multiple of similar public traded companies (over the last 10 years, there has been valuations of 4x to 6x revenue for the median public SaaS company, on average 5x, however with high outliers and variance) and multiple it with your revenue run rate, et voilà: you have an approximate pre-money equity valuation. But what about a SaaS company with current EUR 10k MRR? Is it just worth EUR 600k?
We can learn a lot when looking a little bit deeper at the outliers or variance of public trading multiples in the B2B SaaS space. The companies with revenue multiples higher than 5x also have growth rates higher than the average 30–40% p.a. This growth rate is either based on a larger customer base, same number of customers but with high upselling, and last but not least little logo or negative revenue churn.
Increasing customer base
In order to assess the potential but also possibility to increase the customer base, we must analyse the existing (or benchmark) sales and marketing KPIs. How much does a new customer cost, i.e. customer acquisitions cost, and how much is the return of the customer, i.e. MRR per customer. How long are the sales cycles and how are the contracts and pricing defined. Having a software-as-a-service, customer revenue is little at the beginning compared to on premise business models. That means, the company has to finance in advance sales and marketing costs which leads to more VC financing needs, more dilution etc. On the other hand, yearly upfront payments and long contract durations can have a significant positive effect on the valuation for the founders. All this factors must be taken into account, when looking at and judging the potential increase of customer base.
Moreover, the addressable market is important. It is very unlikely that a venture will gain a market share of more than 10–15% within 5 years or so until an exit. Therefore, if the customer base is limited due to the number of market participants, the growth rate will gradually deteriorate. It will be harder to gain new customers as all potential customers will have been contacted by a sales rep at a certain time. This must be taken into account, when valuing a start-up.
Upselling & IT roadmap
Showing high upselling potential is a big plus in terms of arguing for a higher valuation. If a SaaS venture can show previous upselling of existing customers, there is a high probability that new customers will follow that pattern. There are two types of upselling in the B2B space: feature upselling or license upselling.
Feature upselling “can” be very easy in the B2B SaaS business in terms of delivering the features to the end user. The SaaS can promote new features to the customer while he or she uses the current product. If the user likes it, he can instantly buy the new features. Early stage start-ups, which have been doing sales for just a couple of months are not able to show a previous upselling track record. But they can convince VCs by an impressive IT-roadmap. However, they also must prove that these features are needed by the customers addressed.
License upselling is also very common in the B2B space. Corporates very often start in one department and a couple of licences with a particular SaaS solution. Either the users or the sales rep should promote the software, so other departments will implement the product as well and the venture can show license upselling.
In my opinion, churn rate is only influenced by customer satisfaction (let alone, B2B SaaS firms addressing small businesses which have to deal customers going bankrupt — I call this “natural” churn). What are the reasons, why customers become unsatisfied?
They never needed or wanted the product.
Doing a proper sales job is not necessarily linked to the numbers of customers closed. Pushing potential customers too much into a contract will lead eventually to a high churn rate and bad reputation of the venture.
Customers expected something different.
Related to the topic described above, good sales reps precisely describe and demonstrate the features of the SaaS solution to the potential customer before signing the contract. Moreover, they should have a certain limit in terms of overselling an existing product. Selling features, which do not currently exist, will bounce back with a higher churn rate in the future.
Customers are not actively using the product.
As a SaaS firm, you must make sure, that your customers use your product or derive some satisfaction from it on a frequently basis. It is similar to a one-year gym membership. If you did not work out the last 6 months, it is very unlikely that you will extend the contract.
Customers realize the price is too high compared to competition.
Many ventures start selling their products with little competition. Of course, high prices are very often accepted and paid by the customers. With upcoming competition, customers can compare your product with others. If you have still the best product in the markets, customers will not churn because of pricing. But if the competition is ahead in terms of features, you should rethink your pricing strategy in order to reduce the likelihood of churn.
So, if you have these topics described above under control, your churn rate will be low which will increase the valuation of your start up.
Last but not least, we look at the underlying technology generating the MRRs. The software code of a start-up (should) have an incremental value itself. This value must be considered when evaluating a B2B SaaS venture.
Of course, all these factors described above and the probability of steering the venture in the right direction depend on the management team. Judging the success potential of a management team is based on experience, biases, and a good amount of gut feeling. Therefore, in conclusion, I must agree to Mokwa & Sievers saying: “Qualitative (soft) factors are as powerful as financial statement information in explaining a high-growth start-up pre-money valuation.”
 In 2015, I was an advisor for the bachelor thesis of one of our previous interns, Maximilian Bade. He analysed the challenges of venture valuations in general. His work and insights inspired me to write this short article, not only from an experience-based, but also a scientific-based background about the valuation of B2B SaaS ventures.