GrowthCap Research June 2015 Special Edition: Growth Equity Valuations .GrowthCap, LLC www.growthcap.co Understanding Growth Equity Valuations B2B Software Graybar Building | 420 Lexington Avenue, New York, NY, 10170 Copyright 2015 GrowthCap LLC. +1 (212) 537 0576 All rights reserved. FUELING THE GROWTH ECONOMY ALTERNATIVE CAPITAL FOR PRIVATE COMPANIES GrowthCap advises top performing growth-stage companies on raising private capital from family offices and select institutions. With over three decades of experience its principals have executed over $5 billion in equity and debt financings. GrowthCap's broad investor network is comprised of hundreds of family offices, private funds, alternative asset managers and ultra high net worth individuals. Visit www.GrowthCap.co Copyright 2015 GrowthCap LLC. All rights reserved. Understanding Growth Equity Valuations One of the major points of friction for a Chief Executive Officer raising growth equity is valuation. CEOs, in their attempt to maximize valuation (and therefore minimize dilution to current shareholders), will often point to the surge of “unicorns” — companies that have soared to a $1 billion valuation — or the stalwarts in their space raising mega- rounds at elevated valuations. Investors, on the other hand, will delve into details of the business (the team, the technology, the pace of growth, and market dynamics, among other factors) to determine a fair price. CEOs may tend to emphasize the qualitative factors, striving to prove they deserve an elevated valuation multiple. Sophisticated investors can be more data driven, using financial analysis to support their projections. Investors seek a targeted cash-on-cash return and are most motivated to invest when the entry valuation is aligned with their expectations. Entrepreneurs may have heard the adage: “valuation is more art than science.” While there can be certain imprecision behind how an individual investor or firm will assess value, there are a set of components that investors weigh more heavily than others. They can be grouped into broad quantifiable and non-quantifiable categories: Quantifiable Measures Valuation Multiples Hard numbers drive many investors’ valuation methodologies. All financial valuation stems from one fundamental concept: summing future cash flows to compute present value. The difficulty lies in accurately projecting these cash flows, especially for a fledgling business. And cash flow for software companies in the growth stage is a lagging indicator — they often spend all their profits to secure market share and establish topline growth. Once sales are strong enough to cover the cost of new customer acquisition, true free cash flow generation begins. So while a software company may have no EBITDA, revenue is viewed as a proxy for potential profits. Salil Deshpande, a managing director at Bain Capital Ventures, describes the chronology of multiples used over time as companies expect more aggressive valuations: “Companies used to trade on EBITDA. Then that changed to companies trading on a multiple of sales. Then that changed to forward sales. Now it’s a 2015 Understanding Growth Equity Valuations: B2B Software P a g e | 3 GrowthCap Research | June 2015 multiple on the annual recurring revenue. Now people are going and saying, don’t look at our annual recurring revenue, look at what our year-ending annual recurring revenue will be.” Inferences from M&A Valuations MandAsoft, a mergers and acquisitions data repository based on Berkery Noyes’ Information Industry Weekly, analyzed thousands of mergers in the software industry from 2004 to 2014. The revenue multiple for software companies has been steadily rising over the past decade to a median of 2.9. It is important to note that valuation multiples in merger transactions are typically higher than in growth equity deals due to the acquirer gaining full control of the target (hence, a control premium is paid) and the synergies it expects from the business combination (revenue and/or cost synergies). SaaS M&A: Valuation & Median Revenue Multiples 40 3.5 34 2.9x 35 3 2.6x 30 2.4x 2.5 2.2x 2.2x 25 25 22.5 20.5 2 19 20 1.5 15 EV/Revenue Value Value (US$ M) 1 10 5 0.5 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Value Revenue Multiple Source: MandAsoft P a g e | 4 GrowthCap Research | June 2015 Private vs. Public Valuations Publicly listed companies have historically enjoyed larger multiples than private companies. Recently, however, enterprise software public multiples have experienced a mean reversion, while private valuations have never been higher. SaaS Private Targets: Median LTM Revenue Multiple 4.5 4.0x 3.9x 4 3.8x 3.5 3.1x 3 2.8x 2.5 2.2x 2 EV/Revenue 1.5 1 0.5 0 2009 2010 2011 2012 2013 2014 Q1 Source: Capstone Partners Private company revenue multiples have been steadily rising, from 2.8x in 2012 to 4.0x in Q1 2014. Meanwhile, public company multiples have undergone a significant compression. Tomasz Tunguz, a partner at Redpoint Ventures, underscores this consolidation among public SaaS companies, highlighting how “today, there are fewer and fewer outliers, companies trading at heady multiples, compared to 2014… they now trade within a much narrower band.” Public multiples fell drastically to 6.6x in Q2 2014 after a steady rise from Q3 2013. And Tonguz concludes, “the compression hasn’t impacted valuations in early 2015 Understanding Growth Equity Valuations: B2B Software P a g e | 5 GrowthCap Research | June 2015 venture rounds. Companies are growing faster than ever, a very enticing attribute for investors and higher growth rates command premiums.” SaaS Public Companies: Median Quarterly Revenue Multiple 9 8.4x 8 7.6x 7 6.6x 6.6x 5.7x 6 5 4 EV/Revenue 3 2 1 0 2013 Q2 2013 Q3 2013 Q4 2014 Q1 2014 Q2 Source: Software Equity Group Size Premium Investors also pay a size premium, forgoing growth potential for stability as the chart below illustrates. This premium for larger companies is even more pronounced with top public performers such as Cornerstone OnDemand, Demandware, FireEye, NetSuite, Palo Alto Networks, ServiceNow, Splunk, and Workday, trading at an average of 8x revenue as of Q1 2015. P a g e | 6 GrowthCap Research | June 2015 SaaS M&A: Revenue Multiple By Size 4 450 3.4x 3.5 400 350 3 2.7x 2.4x 300 2.5 1.9x 2.0x 250 2 200 1.5 EV/Revenue 150 1 100 Number Number Transactions of 0.5 50 0 0 $10-20 $20-40 $40-80 $80-160 $160+ Value ($US M) Number of Transactions Revenue Multiple Source: MandAsoft Supply of Capital An increase in the amount of money allocated to invest in private companies leads to increasing competition and prices paid for businesses, which ultimately leads to lower returns. The amount of capital allocated to the private markets has increased substantially in the past decade as more institutional money has been shifting away from public markets and pouring into venture capital and growth equity strategies. Total private equity dry powder, or the amount available to actively invest, topped $1.2 trillion in March 2015, a 14% increase from December. Total uncalled capital commitments have more than tripled over the past twelve years. 2015 Understanding Growth Equity Valuations: B2B Software P a g e | 7 GrowthCap Research | June 2015 Private Equity Dry Power 1,400 1,221 1,200 1,098 1,066 1,057 1,073 1,000 1,002 1,000 955 940 796 800 600 559 401 405 Dry Power Power Dry (US $B) 400 200 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Preqin Fund Manager Profiles All Things Recurring Many software companies benefit from successfully implementing recurring revenue business models despite the initial net negative cash flow that results from foregoing large up-front payments in exchange for smaller, contracted recurring payments. As software companies have shifted to the more stable and predictable SaaS delivery and pricing models, investors have rewarded them with more growth capital at full market valuations. In short, investors will pay a premium for companies that demonstrate loyal customer bases with low concentration and limited churn. Furthermore, companies that have achieved some level of scale have proven they are capable of marketing their products and supporting a customer base over a long period of time, thus reducing the execution risk inherent in most growth-stage companies. An existing subscriber base provides confidence in future revenue projections while mitigating the risks associated with recreating a core revenue base. P a g e | 8 GrowthCap Research | June 2015 Total Addressable Market (TAM) Top-line figures alone do not convey sufficient information about growth and potential of a business. To address these issues, investors consider a company’s Total Addressable Market (TAM). Investors, despite having more tempered expectations than business- owners, strive to sink their teeth in companies that operate in billion-dollar markets with juicy penetration opportunities. For example, out of the 39 unicorns founded since 2003, 17 provide enterprise oriented software solutions. Still, a large market is irrelevant if the product or service has a low adoptability rate due to high switching costs or inferior quality. Executives not only have to be aware of absolute number of potential end buyers, but also of their level of readiness for a new solution and a foreseeable strategy with which you can reach and convert them to loyal customers. Growth Rate To ultimately realize returns and exit the position, investors search for companies with prolific top-line growth rates. Growth decay is faster among non-mature companies — most growth-stage companies cannot consistently triple their revenue year after year. Andy Vitus, a partner at Scale Venture Partners, uses the concept of growth decay to build a valuation framework for recurring revenue companies.