When acquirers buy a sub-scale SaaS business, it’s rarely for the business’s revenue. The revenue-based valuation rules that apply for scaled SaaS companies do not apply sub-scale.
Instead, sub-scale SaaS valuation is based on the particular reason the target is receiving interest, and this can vary.
As I’ve mentioned in previous articles, there are three main reasons why companies acquire sub-scale SaaS: (1) to accelerate a roadmap, (2) to access a new type of customer, (3) to avail a new product to existing customers.
This article will discuss reason #1; you are being acquired because a company believes your tech will accelerate their roadmap. There are 3 factors to consider in this scenario.
Factor 1: Acquirer’s Cost of DIY
The most obvious element of value in buying vs. building is that the buyer doesn’t have to pay their cost to build. I’ve heard a lot of entrepreneurs mistakenly assume that this is the only, or perhaps primary, component of value. “Why would they buy my co. for $X when they could just build it for $Y?” The answer is, there’s value way beyond the direct cost to build. Still, the cost to build represents value and should be factored.
To quantify, first consider the ways in which big companies do things differently. They tend to pay more for labor, they tend to have more project overhead in the form of product & project management, and projects tend to take longer because of all the various functions peering into development.
The extent of these differences will depend on the size of the co., where they’re located, culture. The point is, think in terms of what it would cost the acquirer to build, not what it cost you to build.
Factor 2: Foregone Opportunity while DIY
More than cost savings, the acquirer wants the ancillary benefits of the new feature…just sooner. To quantify this factor, calculate these benefits over the time period it would take the acquirer to develop.
The value might come from any of these effects:
- Increased close rate
- Decreased churn
- Ability to charge more with the new feature
- Cost savings (a more efficient workflow, lower infrastructure costs)
Tiny changes in large revenue streams create lots of incremental dollars. If a big company can have a revenue-impacting feature a few months earlier, it can make a big difference.
Factor 3: Integration & Transaction Expense
No one likes working with someone else’s code. Building it yourself, there’s no learning curve, no undesirable design to undo, no unwanted redundancy, no messy integration. Further, even the smallest acquisitions usually carry a cost surpassing $100K in due diligence and legal expenses. The size of the Integration & Transaction factor will depend on how dissimilar your code is to the acquirer’s, and how complex the transaction. Nonetheless, it’s important to remember to discount the value calculation by Factor 3.
Putting it all Together
The equation for setting your value looks something like this:
Acquirer’s Cost of DIY (+)
- Developer cost at acquirer
- Admin / project overhead cost at acquirer
- Timeframe to complete at acquirer
Foregone Opportunity while DIY (+)
- Time to develop
- Increased close rate
- Decreased churn
- Upcharge potential
- Cost savings from efficiency (workflow, infrastructure)
Integration & Transaction (-)
- Learning curve
- Integration time
- Ongoing redundancies
- Due diligence & legal expenses
You’ve developed a feature that enables a user to create an explainer video with a few clicks. Big Marketing Platform has been working to develop this feature, but it’s been slow going. Competitors have released the feature, prospects are taking notice, and users are starting to complain.
It cost you a small seed round to build the software, but that’s irrelevant. Big Marketing Platform pays its developers $160K/year and it would need 3 of them to build this over the course of 3 months. In addition, the build requires 50% of a project manager’s time at $120K/year and 25% of a product manager’s time at $200K/year. Big Marketing Platform loves meetings, so the 3 month build would likely expand to 6 months.
So the cost is:
Dev. $160K/12*6*3 = $240K
Prod. & Proj. Mgt. ((.5*$120k/12)+(.25*$200K/12))*6 = $55K
Big Marketing Platform’s product is not showing as well as it did before competitors launched the video builder feature, and some current customers are upset. Adding the feature would increase close rate by 5% and decrease churn by 10%. Over the next 6 months, Big Marketing Platform is expected to do $20M in bookings and have $5M in churn. Adding your feature would create (.05*$20) + (.1*$5M) = $1.5M
You’re a small company with limited operating history, and this is an asset sale. So the acquirer’s due diligence and legal expenses will come in at around $100K. You expect that integration and learning curve will take a month, and will involve the full time effort of 3 developers and 50% of a project manager, or $45K. Double that because maintaining someone else’s code sucks indefinitely. So total factor is $190K.
So your value is $295K + $1.5M – $190K = $1,500,105
One big takeaway from this exercise is that the bulk of your value resides in the foregone opportunity. I find this is almost always the case.
A Side Note on Negotiating
Remember, whatever calculation you’ve made will be wrong in the acquirer’s eyes. The acquirer will have its own set of calculations from real inputs, and in their view, will arrive at the right valuation. Use your numbers as a guide to understand how they are thinking about value, but don’t get too stuck on them.
“When they teach you how to drive a racecar, they tell you to focus on the road when you go around a turn. They tell you that because if you focus on the wall, then you will drive straight into the wall.” – Ben Horowitz
Ben Horowitz has a great point. There are a myriad of pitfalls that can kill a startup, and worrying about all of them while trying to execute is a folly.
But I have found that not being aware of them at the outset is also a mistake.
I have spent a lot of my career looking into startups that are falling short of where they aimed originally. They are headed for the wall, if they are not already pinned up against it.
For the most part, these companies were not doomed from the outset by a bad idea. Nor did they make a single big mistake. They usually had one bad habit that ground away at them over time, until the only thing left to do was to make a hard turn to avoid crashing.
The most common bad habits:
- Staying in the basement too long (over-speculating, over-designing, over-building)
- Concession strategy, trying to be many things at once
- Being slow to pivot when the evidence is screaming the right answer
- Scaling prematurely
And you can usually spot the bad habits without having any company history, just by meeting the founders. Founders who love the tech are prone to staying in the basement too long. Founders who are gentle are prone to concession strategy. Founders who talk better than they listen are prone to being slow to pivot and scaling prematurely.
We all have tendencies that pull us in various directions. It’s important to understand those tendencies, and how they can pull you towards the wall if you if you don’t design ways to guard against them.
Weak tendencies, just being aware of them could be sufficient.
Stronger tendencies, you might need to find a co-founder who can counteract.
And the strongest tendencies might dictate which kinds of startups you are capable of leading. For example, I don’t like long odds over long timeframes. I will not build the next Facebook, because in 2006, I would have snapped-up Yahoo’s $1B offer in a second. Had my co-founders disagreed with me I would have remained firm. Had my investors disagreed with me I would have remained firm. And in hindsight, I would have been dead wrong and responsible for an immense disservice to all stakeholders. So knowing that tendency steers me away from taking on go-long / go-huge plays.
In short, know thyself, and study failure before you start. Understanding all the ways in which you could hit the wall will help you set up your venture in a way that lets you focus on the road.
Building a successful VC-backed company requires getting everything just right. Getting it right means hitting a bullseye where three factors intersect: Founder Competency, Market Reality, and Investor Approach.
When you hit that intersection, you have a big exit and sail away to your private island. When you miss, you either hire or negotiate, depending on how you miss.
Let’s start by defining the three factors.
This can be either markets you understand, or innate skills. They will drive your ability to execute well in a one type of venture, and struggle in another. Highly technical founders can have a rocky road building sales-driven orgs, and vise versa. Founders that start in the SMB market might struggle with a pivot into, say, government contracts, even if they spot an open niche. Adapting is hard.
Investors try to stick to a general approach across their portfolio. At the broadest level, most investors look for scalable tech that can create a big category and have a huge financial outcome. Ventures that live in the cracks simply don’t fit in most portfolios.
A level underneath, most investors have some other thesis, or collection of theses, that guide their investments. For example, the aging US population needs accessible tech. Or industries with information asymmetry are ripe for disruption.
Investors usually talk about their approach when raising funds. Deviation merits some explanation, so there’s friction to changing the approach to accommodate a single portfolio company.
Again, adapting is hard.
While Founder Competency and Investor Approach are visible from the outset, Market Reality isn’t totally clear until a venture has been in the market for a while. What we think is going to happen once we’re in market is usually wrong in number of ways. Our customers might be bigger or smaller than we expected. Our core use case might appear from out of the blue by some happy accident. We pivot and adapt, and hope that the pivots don’t take us too far out of our competencies, or our investors’ approaches.
Market Reality Doesn’t Align with Founder Competency: Hire Leadership
When startups find that their Market Reality doesn’t align with Founder Competency, it’s far from a death sentence. If the founders are sufficiently humble, they’ll find leadership that can fill in the gaps. Investors are usually very helpful in tapping their networks for talent.
Sometimes the transition goes well and sometimes it causes fissures. New leadership might change the tenor of the place in a way that demotivates the team. Or they might try to run a playbook that worked for them in the past that doesn’t factor the nuances of the new venture. Overall, misalignment between Market Reality and Founder Competency is sub-optimal, but workable.
Market Reality Doesn’t Align with Investor Approach: Negotiate
VCs rely on reputation for deal flow, so they are generally forgiving towards portfolio companies that are still finding their way. On the other hand, when it comes to re-investing, they have a fiduciary responsibility to their LPs to not “put good money after bad.”
If you find yourself with a decent business, that you are good at running, that doesn’t fit the approach of investors, you’re in a tough spot. You can’t expect your investors to reinvest in a business that doesn’t fit their model, and you can’t expect new investors to come in if your old investors are sending a cautionary signal.
Those lengthy docs you signed as part of your financing are designed (in part) to protect investors in this scenario. What happens next depends on those docs, and your investors’ willingness to make adjustments. The conversations that follow are awkward, humbling, and may not work out in a way that you like. But the next step is always an honest conversation.
One of the keys to making a VC-backed startup work is making sure all parties are aiming for the same bullseye. Also, understanding how you might miss, and the impact to your viability, should be an important factor in deciding whether you want to seek funding at all.
“Sounds like a feature, not a product.” Anyone who has been on the VC trail a few times has probably heard these words. It’s one of the most common reasons for VCs to pass on your business.
It makes sense. Features don’t get to VC scale, and they can easily get knocked-off by large platforms. For example, Google is notorious for obliterating swaths of startups by adding free features to its suite.
The entrepreneur’s response to the feature-not-product dilemma is often to head back to the drawing board and create a bloated vision around the feature. “We’ll add X, then Y, and eventually disrupt market Z!” The problem is that this fills a VC need, but not a market need. In all likelihood, you started with a feature because the market just wants the feature.
Believe it or not, you can create a business out of a feature. It may not be built to last, or get you famous, but it can deliver a better return than a decent exit after several rounds of VC financing (i.e. after dilution & liquidation preference).
Here are some keys to a successful feature business:
Capitalize for a Modest Exit
Don’t take VC for your feature business. Just don’t. Your investors won’t be happy with your modest plan, the market won’t be happy with an artificial attempt to make it bigger, and you won’t be happy when the proceeds from your sub-scale exit go 100% to your investors. If you uncover a scalable business down the road, you can always raise capital then. VC is designed for scale, period.
Embrace Being Invisible
Whereas most businesses cringe at the thought of letting their brand sit in the background, feature businesses should seize opportunities to ride alongside larger brands. There are two reasons for this: capital efficiency and acquisition positioning. Most of the capital burn in software startups goes towards acquiring customers, so if you’re running lean, it can make sense to give up some margin and brand equity to let someone else do your selling. And, this type of partnership can build the business case for eventual acquisition.
Make Hay While the Sun Shines
Remember, your feature business could get undercut at any time by a larger platform. Make conservative long-term plans, harvest profits while you can, and if you get a good offer for the business, take it.
Your Valuation is Not a Multiple of Revenue
Your prospective acquirers will be looking at your ability to accelerate their feature roadmap, bring a new feature to their existing base of customers, or inject a new set of customers into their base. They will not be growing your current standalone business, so it doesn’t make sense for them to value your business based on revenue. As you consider valuation, consider the value that you are bringing the acquirer; it might be considerably higher or lower than typical revenue multiples.
You probably didn’t set out hoping to create a feature business. But if that’s what you have, structure it correctly for the win.
Startup failures send perfectly good tech to the scrap heap. That’s nothing new. What is new is that more and better tech is getting abandoned earlier. It’s an inefficiency created by our convergence around a common playbook.
It starts with taking the path down a very narrow funnel
The standard startup playbook goes something like this: build a product, get some market traction, raise capital, scale revenue, sell for a multiple of revenue. The machine that generates VC returns and founder fortunes has been tuned to this sequence of events.
More often than not, the plan derails somewhere along the way. When the breaking point is revenue at scale, perfectly good tech is often scrapped.
Trouble begins with a big leap from a solution to scalable economics
As entrepreneurs, we look for problems without available solutions. “Hailing cabs is the worst, I wish there were a better way.” Then we create a solution, and can usually find some customers to pay for it.
But a good solution and promising early adoption don’t necessarily portend good economics at scale. As we move beyond early adopters, the cost to acquire customers often outstrips what they’re willing to pay for the solution.
A bootstrapped business that faces this scale constraint can stick to its profitable niche, drop its acquisition costs through channel partnerships, or trim overhead to operate at a slimmer margin. Any of these would be rational moves to keep the business healthy.
However, any of these moves is anathema to the VC-backed playbook. The goal is scalable revenue, and your job is to pivot until you find it, even if the odds start to look slim.
Then, investors get fatigued
The beginning of the end is when your seed investors show fatigue. The runway is getting short, your investors are hesitant to re-up. Without their support, your odds of securing new investors are severely hampered. You are facing a period without cash, or a down round that will likely impact you and your co-founders.
Finally, founders get fatigued
Faced with a down round or a period without cash, you and your co-founders might question the mission. You could look for a buyer, but with a telling P&L and balance sheet, buyers will smell blood and negotiate from a position of strength. Your perfectly good tech is valued as scrap as you near the end of your runway.
By limiting our options, we destroy value
The value of tech and the scalability of a business model are two very different things, but once you are on the VC track, the two become conflated. When the scalable business model fails, it drags the tech down with it.
It doesn’t have to be this way. Good tech can have value within a niche, or wearing another company’s brand, or folded into another company entirely. Just because the tech doesn’t scale as a standalone business model doesn’t meant it is worthless.
When an entrepreneur creates a solution to a problem, it might become an acquirable asset, or a small/medium-sized profitable business, or maybe even a scaled enterprise. Any of those outcomes can create wealth. But in our adherence to a common playbook, we’ve voluntarily crossed two options off the list, and left ourselves with scaled enterprise or bust. The unfortunate result, among other things, is the destruction of perfectly good tech.