Categories Articles, SaaS

This is part of our series on SaaS valuations and IPOs. Read the other two posts in the series about the 2016 venture outlook and trends in tech IPOs.

We’ve all heard it before:

“$10 Billion? There’s no WAY any company is worth that much, especially not a startup that’s only been around for a few years. It’s clearly a bubble.”

The minute you mention unicorns, billion-plus valuations and ballooning venture capital cash to someone outside the startup world, they’ll scoff. No matter what, it always sounds ridiculous to anyone who hasn’t witnessed the rapid acceleration of SaaS startups. Whether you’re talking to your cousin or a friend from college, it can sometimes be tough to explain why exactly a company is valued so highly.

How startups are valued is incredibly complex. It’s influenced by the Venture Capital market, the potential for market growth, and much more. Instead of getting tongue-tied the next time a friend challenges a SaaS startup valuation, you can explain confidently what’s happening in the market to drive that price. Here’s how to explain the existence of unicorns to the most skeptical person you know.

Startups Valued $1 Billion-Plus

2012

2013

2014

2015

10 Startups
15 Startups
38 Startups
66 Startups (so far)

Source: CBInsights

“How are startups raising millions in A, B, C and D rounds of funding?”

Well, let’s say two founders have a great idea for a company, a Minimum Viable Product, and are ready to raise some money. When the founders approach Venture Capital firms in the hopes of raising money, it’s a little bit like dating. The founders are looking to raise the most money without diluting ownership, while VCs are looking for companies with most potential to grow in the future. The earliest investors take on the most risk, while the later investors generally take on less.

As part of the fundraising process, VCs and startup founders agree on a valuation for the company. This number is based on the projected growth of both the market and the company — in some cases, billions of dollars. Funding is essentially a VC purchasing part of the company, so a mutually agreed upon valuation is key. The VC may offer 5% of the company’s valuation in exchange for a 5% share in the company. So if a company is valued at $20 million, the VC will offer $1 million in funding.

“How do Venture Capitalists have so much cash to throw around in the first place?”

Whether it’s HR software or workplace collaboration tools, there is a lot of money being invested in B2B SaaS companies today. Where did it all come from? In the past few years, there has been an influx of new sources of cash in Venture Capital. Specifically, there has been a rise in seed-stage funds and alternative means like crowdfunding, as well as an increase in more traditional sources. This growth in available VC capital is directly tied to the growth in fundraising for startups, and explains a lot of the huge funding rounds you’re seeing in the news.

Venture Capital as an industry tends to be pretty confusing to a layperson, so just stick with the fact that if a VC firm is an early investor in a SaaS startup, they have the opportunity to 100x or 200x their initial investment — if they’re lucky. There’s always a risk that the startup will fail. However, if they invest in 30 early-stage SaaS companies and even just 1 succeeds, that level of risk is worth the reward. Because of this potential for massive returns and the opportunity that exists in the market, there are more and more risk-tolerant VCs entering the space and investing in promising SaaS businesses.

“But seriously, why are startups valued so highly?”

If you’re talking to anyone with a brain, they’ll realize that none of this explains why VCs are agreeing to value startups in the billions of dollars. In fact, it might seem like it’s in a VC’s best interest to keep the value lower in order to purchase a larger share of the same company for less money. The real reasons the valuations are so high is because of a combination of factors in the market that spell out huge opportunities for SaaS startups today.

SaaS is growing exponentially.

Jason Lemkin

“The entire enterprise software stack is being SaaSified,” explained SaaS Investor Jason Lemkin. “Even though IT budgets are only growing with inflation in real enterprise, the percent of that going to SaaS is growing exponentially. That creates a total, utter change in the trillions of dollars spent.”

And this growth isn’t just in the US. The market for SaaS products specifically is just starting to grow internationally.

“The market in India, China, and Brazil is growing rapidly, where the notion of running your business with software is just coming into being,” explained Mamoon Hamid, General Partner at Social + Capital. “Now, there are companies where 40% of their business is international, where a few years ago you were lucky to have 10% of your growth coming from outside of the U.S. In fact, I think there is a lot of growth still to come in the international market.”

All of these factors have combined to make the SaaS startup market incredibly appealing for investors.

“Isn’t this just a bubble about to burst?”

No, it’s not a bubble, but the current valuations aren’t completely accurate either. Many experts in the Venture Capital world have weighed in on this topic, and have clearly proven that today’s tech boom is nothing like the early 2000’s tech bubble. Tech companies today aren’t just buying from each other and not actually bringing in money. While there are exceptions, most startups today won’t disappear overnight. Many of these startups have millions of paying customers. SaaS startups especially, with reliably recurring revenue, are set up for success.  

However, the very real danger is that these valuations are incredibly optimistic. According to Mark Suster, the market is going to experience a correction sometime soon. As some of these billion-dollar unicorns go public, their IPO price reflects a reduced valuation from their last private raise. This clearly shows that the valuations aren’t reflecting the reality of the public market for these products. While this doesn’t classify as a startup bubble, there are a growing amount of companies exiting at lower valuations than their previous rounds, and experts believe the market will readjust in coming years.

Hopefully this helps you bring the facts and some nuance to your conversations about startup valuations. The next time someone challenges you to explain how a small company could possibly be worth billions, you have the information to discuss the issue intelligently.

Cara Hogan
Cara Hogan is a Content Marketing Manager at InsightSquared, where she is a constant contributor to Ramp, the InsightSquared blog, and the host of Ramp, the SaaS analytics podcast. Cara studied Journalism at Boston University and has written extensively about the intersection of technology and business.
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Showing 3 comments
  • Rod Lambe

    Dear Cara,

    I think you are spot on explaining your startup valuation definition. There certainly are a number of variables that would play into making a clear, concise valuation of an SaaS startup. I have enjoyed reading your article, you have certainly done your homework and it does not go unnoticed. I think this would be a insightful article to send to the undergraduate Dean at Babson College, Wellesley, MA. You certainly know of the #1 Entrepreneurial College in the US, having studied Journalism at Boston University, great school. I enjoyed the energy and depth of knowledge the professors would bring real world business experiences into the classroom. I graduated with a B/S in Marketing from Babson College and am forever indebted to the school, which helped shape me as an aspiring business professional! Thank you Cara for the awesome article, I look forward to more of your writing…

    All My Best,

    Rod Lambe

  • Cara Hogan

    Thanks Rod, so glad you enjoyed the post. Babson is a great school as well, and thanks for the suggestion.

    Best,
    Cara

  • Civisisus

    How startups are valued is not “incredibly complex”. It IS incredibly subjective. And the recent tendency of those in a position to put their names on press releases trumpeting those subjective valuations is towards an absurd level of optimism regarding the real prospects of the ‘businesses’ they’ve absurdly overvalued. This isn’t that difficult.

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