Valuing SaaS

[Jurgis]

Looking at some ideas, input, etc. on valuing a SaaS company.

 

For simplicity sake assume monthly $10 fee per customer ($120 yearly).

Assume 2 year+ contract, i.e. no churn for 2 years, then possible churn at 10%+.

Assume TAM 1M customers.

Assume company starting with 10K customers now and growing to 100K in 3 years. And then a wide distribution of outcomes: drop, plateau or capturing up to 100% of TAM (unlikely).

 

If needed, assume 50%+ gross margins, 30%+ net margins on 100K+ customers.

 

How would you broadly value this?

I won't post my thoughts for now to avoid too much anchoring.  8)

[jfan]

I'll take a stab at this:

 

Assuming for each customer, the first 2 years of revenue is $120 each, with a 90% decrease after that. It would take ~ 25-30 years to lose that customer. The PV10 for a customer would be ~ $600.

 

If in 3 years, there are 100K customers, the approximate value (using 30% Net margins) of the business is $18 million. This # doesn't account for any customer acquisition costs.

 

If my personal hurdle rate is 10%, then the max value I would purchase it at would be $13 million or 11x current sales.

 

To make the math easier, I would eliminate it (deal-breaker) if there is a potential of increasing churn rate after year 4 by filtering out maligned management teams.

[Jurgis]

Thanks jfan.

 

I am not sure how you get to "It would take ~ 25-30 years to lose that customer." from 10% annual churn. Seems to me approximately all customers will turnaround in ~10 years.

 

I am not quite sure how you get to $18M value in 3 years.

 

This # doesn't account for any customer acquisition costs.

 

I'd say that net margins account for CAC, no? Although it might be not the best way to account for it. And likely CAC will push down margins way lower in a growth phase than I wrote.

 

You probably should have pushed back on my "then a wide distribution of outcomes: drop, plateau or capturing up to 100% of TAM", since it's so wide as to possibly make this un-valuable and un-investable.

 

So Y3 sales are: 12M. Y3 earnings are 3.6M.

I realize now I am probably way too generous with 30% net margins in 3 years for anything realistic, but maybe. Otherwise we can drop this lower.

 

Post Y3, I'd probably go with some distribution:

25% chance drop off after year 3, value at ~5M or likely zero to shareholders (they may sell to salvage, but may just fizzle off).

25% chance muddle through, not significant growth, so whatever value we put at slow/no growth 12M sales/3.6M earnings company.

25% chance of continued 15-20% growth. Value that at 3-5x Y3 sales - and here we have issue that 3x sales is 10PE because of high margins (/shrug)

25% chance of 20%+ growth. Value that at probably 10x+ Y3 sales. At some point the risk becomes that company get close to TAM which kills growth.

Value these separately, then get estimated value across all of them and discount to Y1.

 

Unfortunately figuring out the distribution is likely very hard.

[jfan]

Appreciate your thought processes on this.

 

I don't know if this is the right way to think about it but here is my logic.

Single customer in Y1 and Y2 provides $120 each year. Assuming that after year 2, it becomes an annual subscription renewal option with a 10% churn rate (ie 10% chance of losing them as a future customer), the expected revenue in Y3 ~ 90% x $120, then in Y4 ~ 90%^2 x $120, and so on and so on. After 10 years, the probability of this customer remaining will be ~ 35%, with an expected revenue of 35% x $120. It will take until year 25, for the probability to drop down to 7%.

 

Taking this expected revenue stream, I discounted it back to present value (10% discount rate), which would give me a present value of ~ $600 for this single customer.

 

Assuming that there is no significant CAC, and the net profit margin once stabilized is 30% (you are right, will likely be much lower if the gross profit margin is 50%), each customer would generate a present value of ~ 30% x $600 of value = $180. If the payback period is 1 year, then the CAC will ~ $120 and the value per customer would drop to $144 or [($600-120)*30%]

 

  (This number is an over-simplication as it doesn't account for growing cash flows with increasing deferred revenues, maintenance R&D, S&M to update software versions, subscription vs usage revenue models)

 

So in 3 years, with 100,000 customers, $180 * 100,000 = $18 million of value on $12 million of revenue or $3.6 million of earnings on a 10% churn rate. It would be more valuable if they can reduce their churn rate over time (if they can drop their churn rate to 0%, then maybe you can think about a value of 10x $3.6 million earnings = $120/0.1 *30% x 100K customers = $36 million)

 

If there is a possibility that the churn rate increases significantly after Y3, then the product is no good, led by an incompetent management team and it would become un-investable. SAAS should be inherently sticky because it allows businesses to see how their clients are using them and give them the ability to layer on needed/desired features. If they can't do that, then trying to sell their poorly functioning intangibles is likely an impossible task.

 

Figuring out their growth rate is more difficult and probably more qualitative than quantitative. This is where I think about the quality of leadership, focus on experimentation, innovation, solving difficult problems, customer focus and delight, open source innovation vs proprietary, degree of industry collaboration, ability to not only grow vertically in their software stack but also to adjacent markets, ease of customer adoption, organizational structure, very large TAM etc.

 

So if I can buy it at $18 million discounted back by 7.5-10%, or at $13-15 million today coupled with a judgment about their ability to reduce their churn rate and skill to grow in a manner that it unexpected (via the above qualitative features) as the free option beyond year 3. Then there is a greater probability of having a reasonable return. (aka Shopify --> Shopify Capital, Amazon --> AWS)

 

Welcome any push-back on my logic.

 

 

 

[Spekulatius]

^ That’s a very good analysis. Thank you for taking the time to lay it out.

[SharperDingaan]

You might want to look at the leasing business models. Typically 70%+ of a lessor is 1-2 big clients paying the bills, with the rest being small clients generating the profit. Profit from small clients subsidizing the net loss on the big ones. Remaining profit going to the investors.

 

Your model only applies to the big SaaS players, and only when in stable state. Smaller players merge/consolidate, fire the big client, and use the lease buyout proceeds to finance the acquisition (&/or go private) ;D . The resultant entity typically ending up as a smaller but materially more profitable company, and a lot easier to manage. Ultimately, the big player then makes the smaller player an offer that it cannot refuse - paying in equity to avoid the tax bite. No change in share count if the big player is also in the market buying shares for cancelation  ;)

 

Industries moving into fintech, is not stable state.

Look at the better players in the fintech space

 

SD

 

[Jurgis]

Appreciate your thought processes on this.

 

I don't know if this is the right way to think about it but here is my logic.

Single customer in Y1 and Y2 provides $120 each year. Assuming that after year 2, it becomes an annual subscription renewal option with a 10% churn rate (ie 10% chance of losing them as a future customer), the expected revenue in Y3 ~ 90% x $120, then in Y4 ~ 90%^2 x $120, and so on and so on. After 10 years, the probability of this customer remaining will be ~ 35%, with an expected revenue of 35% x $120. It will take until year 25, for the probability to drop down to 7%.

 

Taking this expected revenue stream, I discounted it back to present value (10% discount rate), which would give me a present value of ~ $600 for this single customer.

 

Assuming that there is no significant CAC, and the net profit margin once stabilized is 30% (you are right, will likely be much lower if the gross profit margin is 50%), each customer would generate a present value of ~ 30% x $600 of value = $180. If the payback period is 1 year, then the CAC will ~ $120 and the value per customer would drop to $144 or [($600-120)*30%]

 

  (This number is an over-simplication as it doesn't account for growing cash flows with increasing deferred revenues, maintenance R&D, S&M to update software versions, subscription vs usage revenue models)

 

So in 3 years, with 100,000 customers, $180 * 100,000 = $18 million of value on $12 million of revenue or $3.6 million of earnings on a 10% churn rate. It would be more valuable if they can reduce their churn rate over time (if they can drop their churn rate to 0%, then maybe you can think about a value of 10x $3.6 million earnings = $120/0.1 *30% x 100K customers = $36 million)

 

If there is a possibility that the churn rate increases significantly after Y3, then the product is no good, led by an incompetent management team and it would become un-investable. SAAS should be inherently sticky because it allows businesses to see how their clients are using them and give them the ability to layer on needed/desired features. If they can't do that, then trying to sell their poorly functioning intangibles is likely an impossible task.

 

Figuring out their growth rate is more difficult and probably more qualitative than quantitative. This is where I think about the quality of leadership, focus on experimentation, innovation, solving difficult problems, customer focus and delight, open source innovation vs proprietary, degree of industry collaboration, ability to not only grow vertically in their software stack but also to adjacent markets, ease of customer adoption, organizational structure, very large TAM etc.

 

So if I can buy it at $18 million discounted back by 7.5-10%, or at $13-15 million today coupled with a judgment about their ability to reduce their churn rate and skill to grow in a manner that it unexpected (via the above qualitative features) as the free option beyond year 3. Then there is a greater probability of having a reasonable return. (aka Shopify --> Shopify Capital, Amazon --> AWS)

 

Welcome any push-back on my logic.

 

Thanks. I agree with Spekulatius that this is a good analysis.

 

The only part that I would push back without going into concrete details is that I disagree with blanket statement that SaaS has to be inherently sticky and that the only reason for SaaS to collapse is incompetent management selling poorly functioning software. There are a number of SaaS markets where the offerings are very competitive and it is possible to lose market while having OK software and OK management. One example would be no-moat games.