SaaS: Should You Fix EBITDA Margins or Revenue Growth?

First off: You should have a great product. It’s pointless to try and “fix” revenue growth if you don’t have a great product. But perhaps you have too many products, or your prospects don’t understand what you stand for, or your operations are less than optimal. [At the end of this post I will include a laundry list of items we usually see getting “fixed”]

There comes the point when you want to raise a late stage round or prepare a liquidity event (IPO, acquisition, or sale to a Private Equity firm as the new owner). How can you increase your valuation of that round or liquidity event?

Public SaaS Company Financial Ratios as a Proxy

At my venture firm, we have insights into many private companies’ performance and strategies. For mid-stage or later-stage startups can also use public company financial ratios as a proxy — at least corporate development divisions and private equity firms will look at these comps and use them as an anchor for pricing and valuations.

I assembled a list of 65 public companies that offer some aspect of SaaS. Some of them grew up in SaaS; others just added SaaS in recent years — to call Cisco or Oracle a SaaS company would be a bit of an overstatement.  However, these companies do talk a fair bit about turning to a SaaS or otherwise-subscription-based business model in their annual reports. CapitalIQ also aggregates forward-looking revenue estimates from various sources. I pulled these numbers on March 8th, 2018.

NTM Revenue Multiples Companies -- SaaS
65 public companies with a strong commitment to a SaaS or otherwise recurring-revenue business model, segmented by EBITDA margin and NTM revenue growth, as of 03/08/2018 (via Capital IQ)

 

NTM Revenue Multiples -- SaaS
NTM revenue multiples (low quartile, median, top quartile) of 65 public companies with a strong commitment to a SaaS or otherwise recurring-revenue business model, segmented by EBITDA margin and NTM revenue growth, as of 03/08/2018 (via Capital IQ)

Each line in each cell:

  1. # companies with that EBITDA margin and NTM revenue growth estimates, with an average of these companies of <x% EBITDA margin> @ <y% NTM revenue growth>
  2. Companies in that cell on average traded at their <x%> 52-week high of their stock price on 03/08/2018 when I pulled the data, and they have a <y.y> beta compared to the market.
  3. Average <x%> gross margin
  4. Average <x.x> credit health from 1 (great) to 4 (worst). Capital IQ provides an overall company score based on 24 line-items and ratio ranks across three panels: Operational (12 metrics), Solvency (7 metrics), and Liquidity (5 metrics).
  5. Top quartile NTM revenue multiple of Total Enterprise Value
  6. Median NTM revenue multiple of Total Enterprise Value
  7. Low Quartile NTM revenue multiple of Total Enterprise Value

The Devil is in the Detail

At first glance, losing money (EBITDA margin < 0%, lowest row) is better than breaking even (EBITDA margin between 0% and 15%, middle row).  But average NTM revenue growth rates for the lowest row is higher, credit rating better, and gross margins same or better.  The companies in the right-most column (20%+ NTM revenue growth) are also really different animals:

  • 20+% NTM revenue growth, <0% EBITDA Margin: Intellicheck, Zendesk, Gridsum, Everbridge, Q2 Holdings, Proofpoint, 2U, Palo Alto Networks, RingCentral
  • 20+% NTM revenue growth, 0%-15% EBITDA Margin: Bitauto Holdings, IAC, Asure Software
  • 20+% NTM revenue growth, 15%+ EBITDA Margin: Paycom, Veritone

Option 1: Get Better Within Your Peer Group

That, of course, is generally a good idea. What I mean is: Can you improve within your “cell” in the table above? What happens if you improve from a bottom quartile company to a median or even top quartile company within your cell? Will the valuation effect outperform potential downside from higher cost, lower revenue growth, or other side effects on your valuation? As one can see from the table below with NTM revenue multiples of Total Enterprise Value, not all cells have equal “mobility”:

SaaS -- increase within cell

Option 2: Improve EBITDA Margin

Could you improve your EBITDA margin to land in a different peer group? How would that impact your NTM revenue multiples and Total Enterprise Value? The arrows below show two scenarios: (A) You move from a top-quartile company in your cell to a bottom-quartile company in the next higher cell; (B) you move from a median company in your cell to a median company in the next higher cell.

As explained above, this does not make sense for this group, as the companies in each cell are not entirely comparable. It is more likely that you stay in the peer group of your cell but get a higher multiple — in which case the current quartiles of each cell should give you an indication of how much higher that would be.

 

SaaS -- increase EBITDA margin
Effects of increasing EBITDA margin – this does not make sense as the companies in the cells are not true peers and are not entirely comparable.

 

Option 3: Increase NTM Revenue Growth

Again we are looking at the two scenarios: (A) You move from a top-quartile company in your cell to a bottom-quartile company in the next higher revenue growth cell to the right; (B) you move from a median company in your cell to a median company in the next higher revenue growth cell to the right. The case for (A) could be that you sacrifice some EBITDA margin to increase revenue growth, but that comes at a valuation cost. Now, if your decrease in the percentage of NTM revenue multiple is offset by the NTM revenue gain, then your subsequent gain will outweigh the slight decrease in the multiple.

As you can see below, any increase in revenue growth is more likely to result in valuation gains than the above-discussed increase in EBITDA margin for companies with a strong commitment to a SaaS or otherwise recurring-revenue-based business model — but you knew that already, right? What is interesting, however, is how steep the increment is. If you have a negative EBITDA margin but can finance a growth of NTM revenue from 15% to 30% (e.g. growing from $80m to $104m revenue instead of $92m), then your median NTM revenue multiple increases by 60% (e.g. from $460m TEV to $822m), and together a lift of almost 79%!

SaaS -- increase NTM revenue growth

Possible Actions:

Here is a list of possible actions you could take to get better within your cell, increase your EBITDA margin, or accelerate revenue growth:
  • Revise product strategy and roadmap
  • Product consolidation and product innovation
  • R&D roadmap rationalization and strategic changes
  • Go-to-Market transformation
  • Rebranding and repositioning
  • Rebuilt marketing focus around demand generation
  • Transformation of sales architecture to a hunter/farmer model
  • Transformation of sales teams from a “new customer” to “expand ARPU” focus
  • End-to-end cost optimization
  • Optimization of lead funnel operations
  • Professional services transformation
    Negotiation and management of a Transitional Service Agreement in an M&A case
  • Update or redesign of back-office operations and systems
  • Process improvements and offshoring
  • Reduction of real estate footprint
  • Implement SaaS KPIs throughout all organizations and business lines and aligning personal goals and objectives with these KPIs
  • General introduction of unified operational metrics across business units
  • Middle management delayering
  • Vertical or geographic expansion
  • Buying revenue growth through acquisition

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s