In the past I’ve argued that a quick and dirty SaaS valuation was 10 times the annual revenue run-rate times the trailing twelve months growth rate. This formula is a good proxy for valuation but misses a major characteristic: profitability.
Profitability, or lack thereof, is a huge factor in valuing a SaaS business, especially in the age of a pandemic when private investors are more conservative.
The Rule of 40 is a metric that adds the past 12 month growth rate to the past 12 month profitability rate with a value of 40 being good. A value higher than 40 is even better and a value lower than 40 is OK, or even bad depending on how low (or negative) the number.
Personally, I’m a huge fan of the Rule of 40 as it captures the tradeoff between growth and cash burn for startups. Put another way, it presents executives and investors with a simple formula and target using the two most important startup metrics: growth rate and cash consumption.
So, if growth rate and profitability/cash burned combined with revenue run rate are the biggest drivers of valuation, there’s another, more nebulous factor that fluctuates called market sentiment. Take the BVP Cloud Index which has an enterprise value to revenue multiple of 17.3x right now. Wowza, SaaS is hot! This says that for the public SaaS companies, their enterprise value (valuation less debt and cash on hand) divided by their revenue over the last twelve months is 17.3x. Put another way, a company with $100 million of trailing twelve months revenue and no debt or cash would be worth $1.73 billion. The average growth rate for these public SaaS companies is 35.5%. Very impressive. Let’s assume a free cash flow percentage between 5 and 10% and public SaaS companies, on average, are right around the Rule of 40 as a collection.
Now, we know that public SaaS companies at the Rule of 40 are worth 17x trailing 12 month recognized revenue (a lower number than revenue run-rate because there’s growth). Assuming a 35% growth rate, to calculate the rough enterprise value to revenue run-rate multiple, we’ll go back to our example and do $1.73 billion divided by $135 million ($100 million times 1.35 to reflect the 35% growth rate, which isn’t exact as growth usually slows with time) to get a multiple of 12.8.
With the public market average right at the Rule of 40, and the public market average revenue run-rate multiple of 12.8, we can use that are our market sentiment number.
A simple SaaS valuation is the annual revenue run-rate times the Rule of 40 number times the market sentiment. As an example, a $10 million revenue run-rate SaaS company right at the Rule of 40 would be valued $128 million, less some discount for lack of liquidity being a private company.
Long term, I believe the market sentiment will be more in the 4-8 range based on how valuations have fluctuated over time. Pick a market sentiment value here, say six, and a $10 million revenue run-rate SaaS company right at the Rule of 40 would be valued at $60 million. If in this example the company is growing 60% per year and negative 20% free cash flow resulting in a Rule of 40 value of 40, this hits our previous SaaS valuation formula perfectly. In the previous formula, companies burning cash were overvalued and company printing cash were undervalued.
Using the Rule of 40 to think about SaaS valuations captures how growth and cash burn contribute to the value of the business and is a simple, albeit powerful tool.
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David Cummings, Khareem Sudlow
