Software Valuations: A Deep Dive

Today’s focus isn’t on initial public offering (IPO) filings. Details regarding AppLovin’s filing can be found here, and ThredUp’s documentation is available here.

Instead, we are examining software valuations. A comprehensive analysis of the 2020 software market has been assembled by Battery Ventures, and it merits review – the report is accessible here; page references will be provided throughout this discussion – as it offers insights into current software valuations.

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While some degree of overvaluation appears present within the software sector, its location may differ from common perception.

The Battery report contains numerous data points that will be analyzed further this week. However, our immediate attention will be directed toward the increase in overall software multiples, the dissection of multiple expansion based on varying growth rates, and a consideration of the relevance – or irrelevance – of cash flow margins when valuing rapidly expanding software businesses.

Key Areas of Focus

• Rising aggregate software multiples
• Breakdown of multiple expansion by growth rate
• The role of cash flow margins in high-growth valuations

We will also examine the evolving viewpoint of the public market and assess whether the resulting overall picture is favorable or unfavorable for software startups.

Discussions regarding the report’s findings were held with its authors, Brandon Gleklen and Neeraj Agrawal of Battery Ventures. Their expertise will be incorporated to facilitate a more efficient analysis. Consider this a Friday update, or at least, a beneficial one. Let’s proceed.

The report details a shift in how software companies are being valued. Growth rates are playing an increasingly significant role.

Understanding these dynamics is crucial for both investors and founders navigating the current landscape. The analysis provided by Battery Ventures offers a valuable framework for interpreting these trends.

Software Valuations and Rising Multiples

It's undeniable that software company valuations have reached unprecedented levels in recent years. The following chart, provided by Battery, clearly illustrates this upward trend:

This visualization primarily serves to confirm existing expectations. The crucial question now is what will happen next. To analyze the overall trend, it’s beneficial to categorize companies into three growth segments: those with low growth (15% or less annually), mid-growth (15%-30% annually), and high-growth (30% or greater annually).

The same data, when segmented, appears as follows:

This chart demonstrates that companies experiencing the highest growth have witnessed the most significant expansion in their multiples through 2020. Importantly, however, all growth categories have experienced increases in their valuations.

Whether these valuations are justified is a matter of perspective. Battery’s Agrawal explained to TechCrunch that higher growth rates can mitigate the risks associated with valuation multiples. This logic is sound; a company’s rapid growth reduces the potential for a substantial valuation decline should overall software revenue multiples decrease.

Consequently, the fastest-growing software businesses, which have also seen the largest multiple increases, are not necessarily the most vulnerable. Which segment, then, carries the greatest risk? Agrawal suggests that mid-tier companies, while experiencing strong multiple appreciation, are more susceptible due to their slower growth rates compared to the top tier.

This viewpoint aligns with a bullish argument concerning software valuations that has been voiced by several founders and venture capitalists. The core idea is that the software market is larger than previously estimated. The total addressable market (TAM) for software is proving to be so expansive that SaaS companies have a longer runway for growth than initially anticipated.

This is particularly true for the fastest-growing companies, which may sustain robust growth rates for an extended period. Therefore, their valuations reflect investor confidence in a prolonged period of top-line expansion and future profitability.

However, if this same valuation approach is applied to companies with more moderate growth, those growing between 15% and 30% may struggle to justify their valuations. The 8.89x to 17.61x SaaS multiple increase observed in 2020 for the mid-tier segment could signal market exuberance not supported by future performance.

Some correction in valuations across all software growth profiles is possible. Agrawal indicated to TechCrunch that software multiples are currently at a local peak.

Determining which companies are overvalued or fairly valued isn’t necessarily tied to current profitability. The market remains largely focused on growth potential.

To gain a more complete understanding of the software landscape at the end of 2020, consider this additional slide:

Battery explains this data as follows:

In simpler terms, the Rule of 40 continues to be a useful benchmark, but with a significant nuance.

The Rule of 40 posits that healthy software companies can sum their growth rate (as a percentage) and their profitability (as a percentage of revenue) to achieve a total of 40 or higher. The venture firm observed that companies meeting this criterion command higher multiples, and those prioritizing growth within that group are valued even more favorably.

This reinforces the valuation differences observed between different growth cohorts of SaaS companies. As Battery stated in its report, “public markets have shifted back to rewarding growth > growth + profitability.”

This risk-on environment in the SaaS sector is likely to sustain elevated public software valuations for some time. This is positive news for startups, as a renewed emphasis on growth over profits benefits high-growth, cash-burning companies.

Further insights from the report will be shared soon, including contributions from Gleklen. However, we are approaching our self-imposed word limit of 1,000 words. Happy Friday!