This is the story of a venture investor who saw potential in a €4m bootstrapped SaaS company.
When assessing an investment opportunity, an investor, whether a seed, venture, or growth investor, tries to evaluate the possible exit values.
The output of all the diligence before an LOI is a probability-weighted outcomes analysis.
Outcome Analysis for Wix’s sWix’sound led by Bessemer Venture Partners (BVP)
In this real example, BVP bet $2m on a 1 in 100 chance that Wix’s exit value would be $200m in 2011. It’s better odds than winning the lottery. It turned out Wix’s value was $600m in 2014 during its IPO.
To determine possible exit values, investors try to have a comprehensive answer to these two questions:
How long could this company grow at high rates?
What will its margin structure be over time?
Our venture investor bet on the 1% probability that the €4m software company could become the category leader of a subsegment of an existing, large market.
While their competitors, the software giants, were busy going after Elephants (€100k+ ACV) and Whales (€1m+ ACV), the Deers (€10k+ ACV), though numerous, were overlooked.
Recognizing this gap, our investor saw a path for the bootstrapped company to scale from €4m to €100m in ARR. Therefore, he led the €5.2m Series A for 29% equity post-money.
Who wouldn’t?
Unfortunately, the software giants joined the Deer hunt shortly after the investment. This resulted in intense competition, as the freshly VC-backed company, relying on bows and intuition, faced competitors armed with guns and cutting-edge radar.
As a result, the new ARR began to slow down 24 months after the investment. With low odds of getting additional funding, the VC-backed company has to be prematurely pushed into cash flow mode. The goal is to resize the company to reach cash breakeven and rapidly achieve a 30% EBITDA margin.
Below is the Business Plan (BP) on which the investor could perform a new outcome analysis.
Courtesy of the author
According to BP, the 30% EBITDA margin will be reached in 2028, six years after the investment.
When considering the potential exit value of a low-growth software business, the valuation standard primarily revolves around an EBITDA multiple.
At a 12x 2028 estimated EBITDA, the valuation would be around €30m, resulting in a 1.7x cash-on-cash multiple for our venture investor after six years — which isn’t particularly exciting.
Therefore, our venture investor is motivated to recover his capital as soon as possible. This capital could be reinvested in another company in the portfolio that has successfully transitioned from the venture to the growth phase.
The most effective way for our venture investor to recoup his capital swiftly is to align his interests with management’s. Put differently, it means ensuring that the management receives in 2024 what they would have obtained if they had achieved the 2028 BP.
That’s when our venture investor enters into the M&A Buyout territory, assessing what kind of buyers could pay €30m in 2024.
I’ve written before that every company has two customer segments: those buying its products/services (via sales and marketing) and those acquiring its shares (through fundraising and M&A).
The M&A Buyout market is made up of a diverse mix of financial and strategic buyers. For sub-€10m in revenue companies, there are three types of potential customers with different valuation drivers.
TL:DR
Large Tech buyers’ valuation driver is the revenue size.
Software consolidators’ valuation driver is the cash flow engine.
PE-backed scale-ups’ valuation driver is the accretion.
The Large Tech Buyers — These are the companies known for their cash-heavy balance sheets, often making headlines with multi-billion-dollar M&A deals.
Their buying motivation is driven by strategic relevancy, revenue, and cost synergies.
When considering strategic relevancy, target companies often consider product fit, geographical fit, and technological fit, which can lead to revenue and cost synergies.
However, for most buyers, strategic relevancy primarily revolves around the size of the target business relative to their own size. Acquiring a €30 million ARR or €5 million ARR involves the same buying and post-M&A integration processes. These buyers usually have a revenue threshold (often around €10 million) below which they won’t spend time assessing strategic relevancy.
Therefore, our sub-€10m VC-backed company is unlikely to attract serious M&A interest from these buyers unless there’s a working relationship, ideally a go-to-market partnership, before the deal.
The Software consolidators — These are the companies known for acquiring software companies with revenues considered too small by traditional financial sponsors.
They aim to build a portfolio of companies embodying operating features similar to what I’ve termed an Ultimate Software Company.
An Ultimate Software Company possesses a business model with operating characteristics leading to a high level of growing, predictable and durable cash flows.
In simpler terms, they care about a software business generating cash flows—the higher the quality of cash flows, the better the valuation a software company can get from them.
For our breakeven VC-backed company, these buyers will aim to identify areas for potential cost reductions (mainly through staff reductions) to assess the EBITDA for the following year.
As a result, the valuation will be determined based on a multiple of that EBITDA, leading to a valuation range likely to fall between €5 to €10 million…
The PE-backed scale-up — These are the companies backed by financial sponsors known as platforms for add-on acquisitions, which involve integrating smaller, complementary businesses.
Their buying intent is driven by accretion, which refers to the expected increase in exit value resulting from the combined entity being more valuable than its individual parts.
Let’s say a platform valued at €50m acquires an add-on for €10m. The add-on is seen as accretive if, upon exit, the platform’s value reaches €70m. The incremental €10m in exit value reflects the accretion impact.
When assessing the accretion impact of an add-on, these buyers will try to:
understand the add-on’s margin structure over time
determine how the margin structure can be optimized through cross-selling, upselling, and economies of scale during the remaining investment period
evaluate the potential incremental value based on the expected exit multiple.
The impact of an acquisition being accretive differs for each platform.
Often, it’s logical to value a low-growth software company based on ARR multiples instead of the usual EBITDA, even for EBITDA-based exit multiple platforms.
When the expected exit multiple for a platform is based on EBITDA, the ARR valuation logic can be summarized by this formula:
ARR multiple = Add-on expected EBITDA margin * Platform expected EBITDA exit multiple
This means that the ARR multiple can vary widely for our VC-backed company. Here’s a sensitivity analysis of the ARR multiple, considering the expected EBITDA margin of the add-on and the expected EBITDA exit multiple of the platform.
Courtesy of the author
In green is the scenario where our venture investor can recoup his capital while ensuring that the management receives in 2024 what they could expect in 2028.
Note that these ARR multiples represent the highest values each platform might be willing to offer. In real life, they probably won’t offer this valuation directly. Achieving these maximum values depends on bargaining power.
In essence, our venture investor’s ability to achieve his goal depends on the number of addressable platforms. If this number is limited, then our venture investor may simply need to wait for management to realize the 2028 business plan while encouraging them to establish partnerships with large tech buyers.
Thanks for reading!
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