Karen was stuck.
She’d started her SaaS business over 4 years ago. Today, it has 3,000 customers and is doing a little over $2M ARR. She’d laid the first lines of code, hired a team, and raised about $1M through equity. The business is growing at about 5% a month, without a lot of churn.
But it's a grind. Or a knife fight. Pick your metaphor. During the day she is running sales and in the evenings working on product. The business isn’t throwing off enough money to float the team.
It's time to raise an A round or sell the company. The venture offer on the table valued her business at a number that is somewhat insulting. One of her competitors put an acquisition offer on the table that is more generous, but the terms aren’t great. There are no obvious choices.
Which is probably why she was in our Brooklyn conference room last month.
Maybe we could we help?
There’s a ton of knowledge out there around venture valuations and exit multiples. Which is all well and good until you find yourself - like Karen - trying to make sense of the offers on the table. Valuation is art, not science. Nearly all valuation approaches are subjective, colored by who’s doing the valuing and their particular bias.
Except for one.
In this post, we’re going to cover a very specific - and perhaps delicate - valuation methodology: liquidation value.
The liquidation value of your business is the total you could pull out of the business if you want to run it for cash.
Morbid? Perhaps. But it’s the most credible methodology available. Because unlike any other valuation model, liquidation value is based on the business’s actual operating metrics.
SaaS businesses are unique in that they have contracted recurring revenue with predictable behaviors at scale. Outside of assets like hardware and IP, it is a SaaS company’s true asset.
The value of this revenue can be extracted passively.
Put another way, in SaaS you always have the option of running the business for cash until it fades away. In this scenario, costs are minimized, paid growth stops, and you cancel Netjets. The business continues to operate. But only at a level required to maintain the existing customer base.
Some call it “maintenance mode” or "harvesting." We call it optionality.
Should the desired deal fail to materialize, liquidation can be your BATNA (Best Alternative to No Agreement). But let’s be clear: liquidation value represents the floor to the valuations you should be willing to accept.
Ostensibly, the valuation a term sheet should never be less than the liquidation value of the enterprise.
We used this approach to help Karen value her business.
Liquidation value = (Residual value of existing customers + value of organic growth)*(gross margin) + tangible sellable assets
Karen's company, like many SaaS businesses, has no meaningful tangible assets (e.g, hardware, IP). So let’s tackle the first two components individually:
Residual Value of Existing Customers
Karen’s business has the following metrics:
- Paying Customers: 3,000
- Monthly average churn: 3%
- Monthly ARPU: $60
Based on the churn, an average customer would have a life of 33 months (= 1/monthly churn = 1/3%). With an ARPU of $60, we could expect new paying customers to have a LTV of $2,000 (=33 months x $60). The average customer has been with the business for 15 months, based on monthly net add rates. That means that only 55% of the total value remains.
With 3,000 paying customers, the residual value of the existing customers is $3.3M.
Value of Organic Growth
In liquidation mode all paid customer acquisition stops. All growth comes from residual sources such as word-of-mouth, SEO, and account expansion. Assume that you can grow for one year, organically, at a rate equal to your organic growth over the trailing twelve months. Remember, you’re running on a skeleton crew so there is no investment in technology, brand, service, and support.
Karen's business signed 1,600 new customers in the trailing 12 months. Applying the LTV (= 1/Churn Rate * ARPU = $2,000) to these new customers, we get $3.2M.
The final step to Liquidation Value is to total Residual Value ($3.3M) and Value of Residual Organic Growth ($3.2M) and net out the direct cost of supporting the revenue. For Karen’s business, the gross margin was 80%.
Liquidation Value = ($3.3M + $3.2M)*(80%) = $5.2M.
- That $5.2M comes over the course of years, with no discount for the time value of money. So Karen should consider her own opportunity cost of hanging around for four years while the business winds down. This logic, presumably, also applies to the investors who have invested their capital and expertise in the business.
- This formula does not factor the exact age of each customer, which could further degrade the liquidation value.
- Market conditions could change, causing the business to decelerate faster than expected.
Karen now knows that if she transitioned the business into “maintenance mode,” she could expect to pull $5.2M out of the business over the course of next 4 years.
So what did she decide to do?
Turns out, just a few days ago one of her biggest customers doubled its order. So she’s keeping at it, using revenue to finance the business’s growth.
Rock on, Karen!
Want to work out the liquidation value of your SaaS business? Check out this free model.