SaaS Valuations: Intro

I’ve had a few conversations recently that led me to dig deeper into SaaS company valuations. The conversations were along the lines of: 

  • “Workday is trading at 15 times 2014 revenue—that’s crazy!”
  • “Let’s hope SaaS company valuations hold up.”
  • “I need to value [early stage SaaS company]—what are SaaS companies multiples looking like?”

These conversations bother me because embedded in them are a number of incorrect ideas.

In the first, it’s the idea that a 15 times revenue multiple is too high. It ignores the fact that Workday is forecast to grow revenue north of 50 percent in 2014—and that’s on 2013 projected revenue of $425 million. That’s tremendous growth by any standard, but on $425 million it’s incredible. So the number of 15 times revenue tells you nothing.

The second implies the valuations are unreasonable and that we are at the whim of the market in selling shares to the public. The reality is that, one, the valuations are reasonably supported by SaaS company fundamentals and that, two, the market overall is pretty good about aligning prices with fundamentals. At least, it is in the long-term. Not so much in the short-term. 

The third statement is, in part, a version of the first. Most private SaaS company are growing revenue at much faster rates than the public companies. Applying the same multiple ignores that fact.

It’s also flawed because the market for private SaaS companies is very different than that for public SaaS companies. Public SaaS companies have pretty definitively reached escape velocity. They are clear going concerns, whose near-term revenue growth is relatively known. Private SaaS companies are riskier affairs. I argue actually that they reach escape velocity earlier than people seem to think, justifying what many believe are unreasonable valuations. But given the risk at various stages of development, the right way to value them in my opinion is the probability-weighted forecast of an IPO at any given stage.

So I’m going to write three posts to address these and related points. Those posts are:

  • Part 1: The stock market isn’t crazy. Stock market values in general track fundamentals, and SaaS company valuations do so as well. 
  • Part 2: What are the chances? An approach I’ve been toying with builds on that idea. If the IPO values have a dependable logic to them, then the right approach to valuing earlier stage private SaaS companies is a valuation based on the probability that the company goes public. Having seen these valuations done, I know this is what investors in the private market do anyway. I’d just like to formalize this a bit. 
  • Part 3: Embedded options in public SaaS companies. Finally, I’m going to explore a bit whether public SaaS valuations might be missing some key elements of SaaS companies: (1) low downside risk, given recurring revenues and high steady state cash flow margins and (2) dramatic upside potential given (i) their strong competitive positions in large markets and (ii) their R&D and sales/marketing capabilities that allow them to create or acquire complementary products with high growth potential. The low downside risk with upside potential is an option embedded in public SaaS companies that tends to be overlooked.