Trying to nail down a company valuation methodology for a software-as-a-service company from a venture capitalist is like trying to get a politician to stick to a position. It’s virtually impossible to establish a standard approach.
Part of the problem is that pricing largely depends on supply and demand. If a VC believes that your company is highly sought after by other VCs, the price will be higher, whereas if the VC believes he or she has leverage, the price will be lower.
While there’s no single recipe for valuing SaaS companies, here are the five most common criteria VCs use to determine if a business is attractive:
1. Healthy economic model and financial momentum: VCs want to see momentum with respect to financial performance and an economic model that they believe can scale. Basically, they want to know how much every dollar you spend on sales and marketing will yield in bookings. There are lots of different ways to assess this, from the “magic number” to the customer acquisition cost ratio. Regardless, the bottom line is that if you are spending $1 million to generate $200,000 in bookings, something isn’t right.
2. Market size: This is mostly a sniff test VCs use to determine if you can scale your company to the point where it’s meaningful to their funds. If you are building a SaaS company, you will need to prove that if you sell your product for X price, there will be Y customers ready to buy it. Multiply those two numbers together, and you had better wind up north of $500 million.
3. Team: A team that has been there and done that will yield a higher valuation than one with flashy, newly-minted degrees from Harvard Business School.
4. Competitive advantage: VCs typically want to know that what you are building is not only unique, but also really hard to replicate. If they think your product or go-to-market strategy is differentiated, they’ll be willing to pay a higher price. If, on the other hand, they think it’s a commodity, you can’t expect them to return your calls.
5. Exit potential: Is there a broad universe of active and well-funded buyers in your market? If your only path to exit is to be bought by another startup, or if there’s only one large potential buyer for your company, it might be time to consider another market.
Once VCs have determined that a business looks good across these five criteria, they will take a more quantitative path to establishing a valuation. That usually means taking a look at a universe of public SaaS companies and identifying a median revenue multiple (since most of these companies aren’t profitable).
The real challenge is trying to get a VC to value a business’s potential rather than its historical performance. In other words, while VCs often want to value a business based on its historical performance, entrepreneurs prefer to use projections. A good middle ground is looking at a company’s current run rate. That metric generally puts the valuation somewhere between the two parties’ comfort zones, yet allows both of them to rely on a valuation that they feel is rooted in actual data.
Is There Wiggle Room with Valuation Numbers?
The short answer is yes. As with any transaction, both parties always have a different set of variables that they are trying to solve for. The entrepreneur is trying to maximize the cash raised, while minimizing the dilution. The VC, on the other hand, is often (though not always) trying to maximize the cash invested and ownership level purchased. The VCs’ situation is further complicated by the fact they want to invest at a price where they believe they can generate a venture-like return, typically 3x or higher. Ultimately, this mismatch is what drives the biggest disconnect in valuation discussions. Too often the entrepreneur is overly optimistic and the VC overly pessimistic.
Getting to the right valuation can be challenging. Just remember, however, that the best partnerships are forged when both parties leave the negotiating table feeling slightly uncomfortable, but mostly happy.