Originally published on Medium.
- The enterprise value (EV) of a SaaS company at IPO can be predicted almost entirely with just two metrics: 1) the annual recurring revenue (ARR) in the most recent quarter, and 2) the YoY growth rate of that ARR from the year-ago period.
- The relationship between revenue growth and the EV / ARR multiple can be plotted cleanly on a line of best fit that explains an IPO’s price to within 2 turns (e.g., if the plot predicts a 10x EV / ARR, the actual price would be within 8-12x).
- In order to go public, you should have ARR of at least $100 million and a revenue growth rate of 25% or more. In 2018, 26 SaaS companies went public, with a median ARR of $228 million. Twenty-three of those IPOs had growth rates over 25% YoY.
Software-as-a-Service (“SaaS”) companies are characterized by what we finance practitioners like to call “recurring revenues.” They recognize revenue for services that are contractually committed over a period of time, and the revenue repeats consistently in future periods if a customer is happy with the service.
In a well-run SaaS business, a happy customer will stick around for a long time, and the profit that can be made from that customer will increase considerably. On the other hand, if a customer is unhappy, they will churn quickly and the business will likely lose money on the investment that they made to acquire that customer.
There are three keys to success to managing a SaaS business:
1. Acquiring the customer
2. Retaining the customer
3. Monetizing the customer
Acquiring the customer is managed by optimizing your “cost of acquisition” (“COA”) or the “cost of acquiring a customer” (“CAC”), and by understanding the relationship of CAC to the “lifetime value of a customer” (“LTV”) or months to recover CAC. A well-run SaaS company will have a 3:1 LTV:CAC ratio or better and will recover CAC inside of a year.
Retaining the customer is a function of “product-market fit,” the strength of the value delivered relative to other competing alternatives and the costs associated with switching. “Churn” or “attrition,” the percentage of customers who stop using your product or service, is a good way to measure this, along with its glass-half-full counterpart: “retention.” A well-run enterprise SaaS company will get this below 3% per month for paying customers.
Monetizing the customer is dependent on price. For most B2B SaaS companies, this is defined by the “annual contract value” (“ACV”), which is the annual value your average customer contract brings in each year.
What is ARR?
Once a SaaS company achieves positive unit economics by getting LTV, CAC, and churn to the benchmarks described above, the IPO valuation can generally be determined by reference to two metrics:
- Annually recurring revenue (“ARR”). This is not a GAAP metric, and most public SaaS companies don’t report it. That said, it can be derived fairly easily. Typically, ARR consists of committed and fixed subscription or recurring fees. It excludes one-time fees, consulting or services revenue, or variable fees. The SEC form 10-Q generally itemizes these different revenue streams, so you can derive ARR from a company’s 424B or 10-Q by taking the most recent quarter’s qualifying revenue and simply multiplying by 4.
- Growth in overall revenues. Most SaaS companies derive a substantial portion of their revenues from recurring streams, but it turns out that growth in overall revenue is a much better predictor of a valuation multiple in most cases than strictly ARR growth.
Relationship between Revenue Growth and EV / ARR Multiple
Research analysts started using ARR two or three years ago to benchmark the ratio of a company’s Enterprise Value / ARR multiple to bencshmark IPOs.
A company’s “Enterprise Value” (“EV”) is the sum of market cap and long-term debt, less any cash that the company is holding that isn’t being used to fund working capital.
I looked at all 26 SaaS companies that made it to a successful IPO in 2018 or 2019 to see what their ARR looked like at IPO. I took the subscription revenue from the most recent quarter prior to going public and multiplied by 4. That should be a very close proxy to ARR. See the figure below, which has each company’s ARR at IPO:
The median ARR in the quarter prior to the IPO for the group was $228 million. There were a couple of big outliers (Dropbox at over $1.2 billion; DocuSign and Slack were over $500 million) that pulled the mean to around $300 million.
Growth and Valuation
Revenue growth was a very strong predictor of the valuation multiple at the time of IPO.
As you can see, most of these IPOs track nicely along a line of best fit that fairly closely predicts the valuation on the day of the IPO.
The line can be expressed mathematically as y = (g – 15) + 6, where
y is the EV / ARR multiple at the time of IPO; and
g is the YoY growth rate in revenues in the quarter prior to the IPO.
The line would start at the y-axis at about a 6x multiple for a zero-percent growth SaaS company. Every 6 points of annual revenue growth above 15% YoY generates an extra turn on the multiple. For instance, a 21% YoY growth implies a 7x multiple. A 75% YoY growth rate implies a 16x multiple.
Eighteen of the 26 IPOs fell close to the predicted outcome, within about two turns of the predicted IPO price (e.g., if the line of best fit predicts a 10x EV / ARR, the stock would have landed between 8-12x). The median growth rate for these 26 companies in ARR was 39% YoY. The median EV / ARR multiple was about 10.1x (the median EV / trailing revenue multiple was just shy of 11x).
How Did These IPOs Trade?
In most of these cases, the IPOs priced successfully, were oversubscribed, and traded up on the first day. Nineteen of these 26 IPOs rose by over 30% on the first trading day, and the median first-day pop was 45%. That’s a good sign of healthy investor demand.
After a month, the median increase in price was 47%. Just two were trading below the IPO price after on
e month, Domo and SurveyMonkey.
Explaining Some of the Outliers
Five companies did much better than simply looking at the growth rate would have predicted. In two cases, Pivotal Software (NYSE: PVTL) and Dynatrace (NYSE: DT), the companies probably benefited from meaningful and profitable non-recurring revenues, which obviously helps with the financials.
Pivotal generated nearly 40% of its revenues in its pre-IPO quarter from consulting services supporting its developer-tech platform. Pivotal’s pricing and valuation were also affected by its unusual relationship with Dell, which owned about 70% of Pivotal at the time of its IPO (and controlled about 96% of its shareholder voting rights). A significant part of Pivotal’s business was sold in conjunction with DellEMC and VMware, accounting for 37% of its revenue. These factors probably helped pricing by offering a floor under the price, while muting the expected first-day pop in price.
Dynatrace had about 20% of its revenues from the sale of licenses and the delivery of services. Meanwhile, Dynatrace grew its ARR by over 40% in its pre-IPO quarter, and if we use that instead of the growth rate in overall revenue (around 17%), Dynatrace would have landed smack on the line of best fit.
The other three were Slack Technologies (NASDAQ: WORK), which priced at a very rich 25x EV / ARR multiple; Datadog (NASDAQ: DDOG), which went out at a whopping 29x EV / ARR, the highest of the group; and Cloudflare (NASDAQ: NET) at 18x EV / ARR.
Slack likely benefited from almost universal name recognition among small business owners. It is the closest thing to a “retail stock” among the 2019 SaaS IPOs. Slack also benefited from having significantly more scale at the time of its IPO than its peers. At over $450 million in trailing annual revenues, it trails only Dropbox and DocuSign among its peers and priced at the perfect time in a hot market in June. However, as anyone who bought into that stock now knows, the stock struggled and ended up trading well below its IPO price for most of the second half of 2019.
Datadog is trading near $63 per share today (twice the IPO price) and sports a market cap of over $18B – a multiple of over 50x. It seems that they have been able to participate in a few large markets with lots of runway-building analytics solutions for IT professional and developers, and now also in security monitoring.
One company that falls fairy significantly below the line is Ping Identity (NASDAQ: PING), the Bay Area identity security company. I reckon that that deal priced at around a 6x EV / ARR multiple and perhaps came public at a turn or two below where they should have given the chart above (i.e., at 6x vs. 7-8x). But there were some other factors at play here. First, Vista Equity Partners continued to hold 80% of the outstanding equity, and investors may legitimately have wanted to avoid such a heavy overhang of potential sales. Also, Ping demonstrated considerable volatility in their subscription revenues in the quarters leading up to the IPO. That’s very unusual for a true SaaS company and may have reduced the appeal of the offering. PING indicated in their 424B that they “sell [their] platform through subscription-based contracts, primarily with either a 1-year or 3-year term, making the average contract term approximately 2 years. Substantially all of our customers pay annually in advance.”
While that sure sounds like a SaaS company, check out the trajectory of their quarterly subscription revenues, compared to some of the other 2019 IPOs.
The other company that priced well below the line, and which hasn’t performed well since the IPO, is Domo, Inc. (NASDAQ: DOMO). Financially, they are suffering from a very high cash burn, elevated customer churn versus peers, and rapidly declining revenue growth.