- The G-A EV / ARR Ratio (“Ratio”) normalises growth for Business to Business (B2B) Software as a Service (SaaS) businesses. It asks the question – for each percentage of ARR growth, how much am I paying?
- Formula = EV / ARR Multiple divided by (Year on Year (YoY) ARR Growth*100) [Example Company: 9 / (109% *100) = 0.831 (or 8.31%)]
- The median Ratio on the ASX is 20% (or 0.2), while the average for US listed B2B SaaS companies is 40% (0.4), twice that of the average ASX
- Apply the median 20% G-A Ratio to benchmark an ASX listed B2B SaaS company to see if a company is over or undervalued comparatively to other companies in the industry
- If you pay a 20% Ratio then this will more or less line up with EV / ARR multiple that VC / Private Equity pays for B2B SaaS companies based on growth of ARR and size of ARR (for example, a company with $5m ARR growing 100% usually commands a 20x EV / ARR multiple and this equals a 20% Ratio)
- If a company has a 20% Ratio then this doesn’t mean that it is fairly valued, it is a just a benchmark. You then need to look deeper into the company’s financial information, unit economics, operational metrics and qualitative factors to make sure that all of those matters are high performing (the company can efficiently and robustly grow, not spend $1 to make 80c)
- So, the Ratio separates those companies into those that are at least fairly priced and those that are not. From there you can focus on doing diligence on those that you won’t potentially over pay for.
What is the Growth-Adjusted (G-A) Enterprise-Value (EV) Annual Recurring Revenue (ARR) Ratio, and why is it important?
The G-A EV / ARR Ratio (“Ratio”) normalises growth for Business to Business (B2B) Software as a Service (SaaS) businesses. It asks the question – for each percentage of ARR growth, how much am I paying?
The formula is:
Formula = EV / ARR Multiple divided by (Year on Year (YoY) ARR Growth*100)
Example Company: 9 / (109% *100) = 0.831 (or 8.31%)
Why is normalising growth important?
Now take for example 2 B2B SaaS businesses, Company A and Company B.
Both are growing their ARR at 100% Year on Year, but Company A has $5m ARR and Company B has $10m ARR.
How do you know how much to pay or what EV / ARR multiple it should attract? You don’t know if it’s over-valued or under-valued relative to other B2B SaaS companies.
It’s almost impossible to know, unless you have some sort of benchmark.
Growth-Adjusted (G-A) revenue is not a new concept, but is one that is rarely applied in the B2B SaaS space.
For example, a Private Equity (PE) firm that pays a 4x multiple on revenue for a (non B2B SaaS) company that is growing 20% is buying in at a 0.2 G-A EV / Revenue Ratio. This was spelt out in Dave Kellog’s blog post “Are we due for a SaaScre?“ where I came across the concept and is one of the few, or only sources that I could find on the topic.
So, let’s use the ratio that PE firms use (0.2 or 20%) as a benchmark and compare Company A and B above using real ASX examples.
How we apply this normalisation method to SaaS companies can be seen by comparing the following 2 companies:
- Company A = “K2fly” (ASX:K2F)
- Company B = “Pointerra” (ASX:3DP)
If we look at the “G-A EV/ARR” column, K2fly has a 5.04% ratio while Pointerra has an 8.31% ratio, which lines up with their respective EV/ARR multiples (5 and 9, respectively).
What this is saying is that you are paying well below the 20% for either, and purely on this ratio K2Fly is more undervalued than Pointerra. However, this ratio alone is not sufficient to make that call, this is just one metric in isolation for educational / informational purpose. To make an informed decision on value, investors need to look at a range of financial information, unit economics, operational metrics and qualitative factors when assessing B2B SaaS companies. All of these things are covered in similar blog posts to this one (there’s a list of each at the bottom of this blog), and tied back to together in company profiles. Also, you can find a list of all ASX B2B SaaS companies on the ASX that disclose ARR here (with the information included in the images above and below).
As you can see from the table below, if we normalise growth and use the 20% Ratio as a benchmark, then K2fly and Pointerra are approximately 75% and 58% below their value based on the 20% Ratio (the last column below under 20% Difference).
Formula = EV / ARR Multiple divided by (YoY ARR Growth*100)
Pointerra: 9 / (109% *100) = 0.831 (or 8.31%)
How can you rely on such a benchmark that’s just made up and comes from companies with normal revenues not ARR?
I asked myself that question, and found that the median Ratio on the ASX was 20% (exactly the same as the ratio Private Equity pay). The range of ratios across 40 ASX listed B2B SaaS companies is from 5% to 150% in the table below. While the average for US listed B2B SaaS companies is 40% (0.4), twice that of the average ASX.
So, if we use the 20% benchmark that PE firms and compare it to intelliHR’s 8%, then it is valued quite low given how fast it is growing (especially when you compare it to Megaport where investors are paying almost 5x more (40% Ratio) for each % of grow in ARR, which means its extremely expensive relative to the 20% Ratio benchmark). Then, if we look at K2fly at 5%, it seems to be a bargain (almost half the ratio that PE firms pay, 20% for slow growing traditional companies) as you are paying very little for each percentage % growth in ARR.
You want to find the fastest growing SaaS companies with the lowest Ratio because you are paying the least amount possible for each percentage of ARR growth relative to other companies.
You want to find companies in the top left hand corner of the this graph, the 20% or below (you are paying the least for growth – meaning they are relatively cheap for how fast they are growing) as they are ‘cheap’ and growing the fastest. The sweet spot is the purple circle, fastest and cheapest.
That all sounds great, but how does it relate to EV / ARR Multiples used to value B2B SaaS companies?
For many years I was asking what the rationale for 20x multiple for a company growing ARR at X, why 20 and not 30, what’s is the logic behind it. It seems that by accident I stumbled across the rationale. The multiple paid almost perfectly aligns with the 20% Ratio.
If you pay a 20% Ratio then this will more or less line up with EV / ARR multiple that VC/Private Equity pays for B2B SaaS companies based on growth of ARR and size of ARR (for example, a company with $5m ARR growing 100% usually commands a 20x EV / ARR multiple and this equals a 20% Ratio).
What the table below is saying is if a B2B SaaS company is growing at a certain speed and between a certain ARR range, it belongs in a certain percentile (90th Percentile being Hyper Growth, 75th Percentile being Fast Growth, 50th Percentile (Median) being Growth and 25th Percentile being Low Growth). These metrics are global benchmarks taken from the last few years across public available resources, articles etc.
Then, in the table below, it shows a corresponding multiple based on size of ARR and Year on Year (YoY) growth in ARR. The multiples are global benchmarks for B2B SaaS multiples from the last few years.
So, if we now take Pointerra growing 100% YoY at $20m ARR, it is a Hyper Growth company that is trading at an 8% Ratio, but based on the table above it should be trading above 20x EV / ARR multiple and have an almost $800m valuation (a 20% Ratio).
Check it out for yourself using the table below and the list of ASX B2B SaaS companies here.
The 20% Ratio matches the global benchmarks for B2B SaaS multiples.
However, as you can see from the word “Weighted” in the top left hand corner of the table above, the multiple applied is weighted across many factors, of which, YoY ARR growth is one. If the company is spending $1 to make 80 cents then that business is not sustainable, and its inefficiencies (risks and poor operations) should be weighted into the multiple. Any company can grow at 90th percentile rates, but if it cannot do it efficiently then it will crash and burn or its growth will stall (you’ll have paid for a rocket ship and are stuck with a pony, which might take you 5-10 years to break even).
So, what do you need to do once you’ve found a fairly valued or ‘cheap’ B2B SaaS company?
Simple, but probably not what you want to hear. You need to do proper due diligence. But why? Shouldn’t the Ratio be good enough.
It’s just a guide that should steer your attention and effort to companies that you can underpay or pay a fair value for.
To properly perform due diligence, and weight the quality of a B2B SaaS company you should look at the following operational metrics, unit economics and qualitative factors:
Unit Economics & Operational Metrics
- Year on Year (YoY) ARR Growth Rates
- EV / ARR Multiples
- Growth Persistence
- Growth Efficiency
- Gross Profit Margin
- R&D as a % of ARR vs S&M as a % of ARR
- Sales and Marketing Expense Ratio
- Magic Number (Sales and Marketing Efficiency)
- Sales OTE to ARR Ratio
- Net Promoter Score (NPS)
- Net Dollar Retention
- Payback Periods and Customer Acquisition Costs (CAC)
- Quick Ratio
- Monthly Burn per FTE by ARR
- General and Administrative Spend as a % of ARR
- Number of Employees
- Vertical vs Horizontal Software Solutions
- Network Effects
- Product Led Growth (PLG) [Bottoms Up Sales] vs Normal Sales [Top Down Sales]
- Organic vs Inorganic ARR growth
- Type of clients (Small Business, Mid Market and Enterprise)
- Competition and Target Addressable Market (TAM)
By using the factors above, you can make a call as to what kind of weighting the company deserves. For example, a company might be in Hyper Growth and on the face of it command a 20% multiple, but you know that their sales people cannot hit targets, they cannot up sell clients, their marketing spend is increasingly disproportionate to the amount of ARR growth signalling saturation etc. As a result, you might apply a 10x multiple instead to factor in the risk, or avoid the company entirely.