5. How Does Burn Productivity Drive SaaS Valuation?… A Practical Example
Venture Capitalists are renown for valuations that are often grounded in significant subjectivity that defy typical valuation methodologies — my Partner at e.ventures, Brendan Wales, has written extensively about the difference in the evolution from Perceived Value at the early-stage (i.e. pre Series B) to Intrinsic Value at the later stages (Series B onwards).
At the point venture-backed SaaS companies reach Growth Stage at Series C, even Series B, they will have built up a body of work on their Burn Productivity, which is a mixture of their market opportunity, product, go-to market motion and of course, execution.
This Burn Productivity (defined in this link), when stabilized, can be a key determinant in valuation. This analysis tries to simplify why it is crucially important:
- A sensitivity analysis of Burn Productivity on future revenue and earnings
- Reiterating why this higher earnings potential drives higher valuation
- The ability of companies to maintain Burn Productivity
Feel free to drop me a note if you have any questions or thoughts.
How are valuation decisions made?
Case 1–0.30x Burn Productivity
For a refresher, please refer to this link on the calculation of Burn Productivity— and its summary copied below:
Let’s assume we have a theoretical company (“Case 1”) at $500M in LTM revenue, generating $350M in Gross Profits and spending $400M in Opex to result in EBITDA losses of [$50M] — a fairly typical representation of a SaaS company today. Case 1 has historically generated a Burn Productivity of 0.30x — solid, as its ahead of the 1Q 2020 SaaS median of 0.24x.
If we assume that Case 1 that for the next 7 years:
- Continues to grow Opex at 20% p.a (SaaS company entrepreneurs typically forecast revenue according to the productivity of opex investments and the availability of cash)
- Gross Profit margin stays stable at 70%,
- Burn Productivity remains stable at 0.30x,
Case 1 will achieve Revenue / EBITDA of $2.7Bn / $0.47Bn by the end of Year 7, on 17% EBITDA margin.
Case 2–0.60x Burn Productivity
For a theoretical Case 2, assuming all the exact same parameters as Case 1, only changing Burn Productivity to 0.60x (top-quartile of SaaS companies today), Case 2 will generate Revenue / EBITDA of $4.9Bn / $2.0Bn by Year 7.
A drastic difference compared to Case 1 (nearly 2x larger revenue, 4x larger EBITDA)
Indeed, if we flex Burn Productivity between 0.20x and 0.70x, you can observe the meaningful change in Year 7 Revenue and EBITDA per below.
Long-term Revenue/EBITDA/margin assuming varying Burn Productivity on constant Opex growth
Public investors valuing SaaS businesses will consider this calculus in their valuation by discounting (i.e. DCF / NPV) these future expected earnings. The above is obviously this is an overly simplified explanation, as market, competition etc will impact a company’s ability to drive the abovementioned growth and Burn Productivity metrics longer term, but this is directionally indicative.
Why does Burn Productivity Affect Valuation?
A vast majority of publicly-listed, let alone private, SaaS companies are valued on enterprise values that reflect future earnings potential, given the lack of profitability today. Extrapolating a company’s future earnings and capitalizing them (i.e. placing an earnings multiple on them) allows us to visualize the valuation impact of Burn Productivity.
Using the above chart’s Year 7 EBITDA for Case 1 and Case 2, and applying a 15x EBITDA multiple (a fair multiple for a mature, flat-growth business), drives Enterprise Value / Market Cap of $7Bn and $30Bn respectively — a vast difference.
Long-term Enterprise Value assuming varying Burn Productivity on constant Opex growth
Can Companies Maintain Burn Productivity?
A logical question for entrepreneurs to ask is whether Burn Productivity can be maintained over time — it would be reasonable to assume that upon market saturation that the marginal gross profit added on each dollar of Opex would begin to decrease. That is why it is important for entrepreneurs and investors to focus on a company’s ability to expand beyond existing use cases in building a broader platform that captures broader wallet share of a larger set of customers — a core tenet of our investing at e.ventures.
Acknowledging survivor bias, there are many examples of companies that have been able to sustain Burn Productivity at scale. The companies below are sorted by market cap where financial data extends back to 1Q 2017 — a comparison of 1Q 2020 Burn Productivity vs. 1Q 2017 shows that these companies have been able to broadly maintain their Burn Productivity over time even when ARR is surpassing $1Bn. Each of these companies has its own strategy and tactics in being able to achieve this (i.e. Salesforce, Workday and ServiceNow expanding beyond their core recognised offerings).
Burn Productivity for the Largest SaaS Companies
Burn Productivity Is a Key Determinant of Profitability and Valuation
While entrepreneurs may not be immediately focused on Burn Productivity, it is worth paying attention to longer term given the clear valuation impacts. While valuation is impacted by a multitude of factors including market, growth, product etc, a number of these can be captured in Burn Productivity. Growth, Magic Number, Payback, Rule of 40 are all great metrics to track — but it pays to also focus on Burn Productivity given the direct impacts on valuation longer term.
Other topics in the series:
Introduction — SaaS ‘Burn Productivity’… Better Than Magic Number and Rule of 40?
- SaaS Financial Benchmarking… One Size Doesn’t Fit All, and Focusing on Gross Profit — benchmarking growth, margins and opex items
- What Financial Ratios Should You Go Public With?… And What Should They Look Like Longer Term? — P&L ratios at various stages of their growth curve, from pre-IPO through to large scale, and why there is no ‘one size fits all’
- Magic Number and Rule of 40… Helpful, For Now — Showing that these metrics haven’t always been correlated to higher valuations
4. ‘Burn Productivity’… A Consistently Better Signaler of SaaS Valuation — Defining Burn Productivity and its stronger correlation with valuation owing to its capturing of product-led growth
5. How Does Burn Productivity Drive Profitability and SaaS Valuation?… — A Practical Example — Valuation and its stronger relationship to Burn Productivity via a first-principles look at the drivers of valuation