To The Moon

Can Subscale Software Companies Go Public?

This debate has been going on for a couple months now - “can software companies with <$500m of revenue go public.” Or said another way, has the bar gone up to go public. There was more conversation on this topic this week, with some good commentary below

I really found myself agreeing with this, and had a couple tweet responses that I’ll summarize here. Software companies can certainly go public with $150m in revenue. You just have to be willing to accept the market clearing price, which very well may be 6x revenue. And that’s really hard when private markets are valuing you at 30x. There’s a valuation airpocket when the gap between private market and public market multiples is this wide.

The challenge is private markets are FULL of companies who were growing 50-100% at ~$100m of ARR, who are now growing <20% at $200-$300m ARR. And there are many reasons for this. Some listed below:

1. TAMs were captured sooner and companies didn’t scale into their next product line

2. Large incumbents bundled them

3. Execution challenges popped up

Scaling to $500m of revenue is HARD! If the public markets valued a company at 15x revenue who was growing 50-100% at $100m of revenue, who then saw growth decelerate to 20% at $250m, the multiple compression would eat away all of the returns. A company growing 20% at $250m of revenue very well may trade at 5x revenue. And that would leave every public market investor who invested at $100m of revenue underwater.

Unfortunately, I’d wager the majority of companies in hypergrowth mode at $100m of ARR have seen serious growth decay over the last few years. And so the only way for investors to have made money on them (if they were in fact public at $100m of ARR) would have been by paying 5-6x revenue initially.

This mentality persists today. Instead of paying up for subscale companies (and therefore making the implicit bet that growth will endure for longer), public investors would rather pay a price today that doesn’t bake in “aggressive” forward growth assumptions. “We’ll believe your growth will endure and margins leverage will follow when we see it! And only then will we pay a premium multiple.” And this leads to a lack of demand for the sub scale companies at premium multiples (irrespective of your growth). This of course creates a huge opportunity to “pick right” when investing in smaller cap companies! Not every company will see growth decay that aggressively. Look at $MongoDB Inc.(MDB)$ .

Markets are cyclical, and this all of course could change. But for now, these appear to be the market dynamics. And the high valuations of private rounds appear to make it harder for subscale companies to go public. I say “appear” because there’s nothing actually wrong with a down round IPO (unless you’re a VC who’s marked up your portfolio to the last round price and raised funds on these paper marks…). But when you have massive pools of late stage capital all momentum chasing the same companies it leads to inflated private valuations relative to the public markets. And if companies went public at 5-10x revenue, then the late stage venture markets would crumble. This leads to a lot of venture investors saying the public markets are closed to subscale software companies simply because the public markets are not willing to value businesses the same way they are.

Another dynamic in play is that it’s just very easy to be private right now. Venture markets have expanded massively over the last decade. 10 years ago, if you wanted to raise $100m+, there were very few options outside of the public markets to raise that quantum of capital. Today, there are many firms who wouldn’t think twice before writing a check that big (or multiples of it!). Regulations around public companies have also increased. And finally, there are plenty of liquidity options for employees of late stage private companies. Going public is no longer the only way to get liquidity. Many late stage companies execute annual or semi-annual employee tenders for employee liquidity.

Top 10 EV / NTM Revenue Multiples

$CrowdStrike Holdings, Inc.(CRWD)$ $Palantir Technologies Inc.(PLTR)$ $Cloudflare, Inc.(NET)$ $Datadog(DDOG)$ $ServiceNow(NOW)$ $Samsara, Inc.(IOT)$ $Palo Alto Networks(PANW)$ $Snowflake(SNOW)$ $Zscaler Inc.(ZS)$ $HubSpot(HUBS)$

Top 10 Weekly Share Price Movement

Update on Multiples

SaaS businesses are generally valued on a multiple of their revenue - in most cases the projected revenue for the next 12 months. Revenue multiples are a shorthand valuation framework. Given most software companies are not profitable, or not generating meaningful FCF, it’s the only metric to compare the entire industry against. Even a DCF is riddled with long term assumptions. The promise of SaaS is that growth in the early years leads to profits in the mature years. Multiples shown below are calculated by taking the Enterprise Value (market cap + debt - cash) / NTM revenue.

Overall Stats:

• Overall Median: 5.2x

• Top 5 Median: 15.7x

• 10Y: 4.3%

Bucketed by Growth. In the buckets below I consider high growth >27% projected NTM growth (I had to update this, as there’s only 1 company projected to grow >30% after this quarter’s earnings), mid growth 15%-27% and low growth <15%

• High Growth Median: 10.3x

• Mid Growth Median: 7.6x

• Low Growth Median: 3.8x

EV / NTM Rev / NTM Growth

The below chart shows the EV / NTM revenue multiple divided by NTM consensus growth expectations. So a company trading at 20x NTM revenue that is projected to grow 100% would be trading at 0.2x. The goal of this graph is to show how relatively cheap / expensive each stock is relative to their growth expectations

EV / NTM FCF

The line chart shows the median of all companies with a FCF multiple >0x and <100x. I created this subset to show companies where FCF is a relevant valuation metric.

Companies with negative NTM FCF are not listed on the chart

Scatter Plot of EV / NTM Rev Multiple vs NTM Rev Growth

How correlated is growth to valuation multiple?

Operating Metrics

• Median NTM growth rate: 12%

• Median LTM growth rate: 17%

• Median Gross Margin: 75%

• Median Operating Margin (10%)

• Median FCF Margin: 14%

• Median Net Retention: 110%

• Median CAC Payback: 53 months

• Median S&M % Revenue: 40%

• Median R&D % Revenue: 25%

• Median G&A % Revenue: 15%

Comps Output

Rule of 40 shows rev growth + FCF margin (both LTM and NTM for growth + margins). FCF calculated as Cash Flow from Operations - Capital Expenditures

GM Adjusted Payback is calculated as: (Previous Q S&M) / (Net New ARR in Q x Gross Margin) x 12 . It shows the number of months it takes for a SaaS business to payback their fully burdened CAC on a gross profit basis. Most public companies don’t report net new ARR, so I’m taking an implied ARR metric (quarterly subscription revenue x 4). Net new ARR is simply the ARR of the current quarter, minus the ARR of the previous quarter. Companies that do not disclose subscription rev have been left out of the analysis and are listed as NA.

https://cloudedjudgement.substack.com/p/clouded-judgement-62824-can-subscale