👀Why Revenue ≠ Revenue! How to See Past the Blanket Revenue Multiples Put on Companies

Let’s start with the known.

All revenue is not valued equally. This is obvious, but in case it’s not, just take a look at the chart below from Jamin Ball’s Clouded Judgment that lays out valuation multiples for SaaS companies, among other metrics.

As stated in the chart, Snowflake is trading at a 20.2x last twelve months (LTM) revenue, while New Relic is trading at a 6.0x LTM revenue multiple. There are a large number of reasons for this, but this is particularly relevant for LPs in SPVs as GPs often state ARR multiples in their materials without discussing the nuance around these multiples; instead LPs must rely on the limited information provided in these memo’s to determine if the multiple is justified.

There are other multiples frequently used to determine valuations outside of ARR or Revenue multiples, like FCF (free cash flow) multiples or PE (price to earnings) multiples, but the reality is most venture stage companies are not generating any free cash flow or earnings so we must rely on some valuation framework to compare them.

Similarly, discounted cash flow (DCF) valuation assumptions are relatively useless for valuing early stage companies; you can create a model with a large number of assumptions, and it may be helpful in thinking through the levers of a business and understanding the business overall, but it is not particularly useful when it comes to determining a precise valuation given early stage companies are by nature volatile and unpredictable and even missing one major assumption can throw the entire DCF off. Additionally, it’s not something LPs in SPVs are able to do with any accuracy (to create a proper model it would candidly require management input and deep analysis).

So this takes us back to revenue & ARR – perhaps the best metrics we have to create a comp for a business and overall understand the value of a dollar of their revenue.

So what are the levers that are most important in determining what is a fair revenue multiple for a business. Here are some of the major ones:

• Revenue Growth - Rate at which revenue is increasing. Faster growth is generally better.

• Free Cash Flow (FCF) - The cash a company has left after paying for its operating expenses and capital expenditures. Positive and growing free cash flow is desirable.

• Gross Margins - Revenue remaining after accounting for costs of goods sold. Higher margins are better.

• Contribution Margins - Revenue remaining after variable costs. Higher is better.

• Profit Margins - Net income as a percentage of revenue. Higher margins indicate efficiency.

• Unit Economics - Revenue and costs associated with each product/unit sold. Positive unit economics indicates a viable business model.

• Predictability of Revenues - How consistent and predictable future revenues are expected to be. More predictability lowers risk.

• Diversification of Revenues - Having multiple revenue sources lowers customer/market concentration risk.

• Defensibility of Revenues (or Stickiness of Revenues) - How well revenues are protected and likely to recur. More defensible & sticky revenues are desirable.

• Net Revenue Retention - Measures the change in recurring revenue from existing customers over a period of time. Over 100% indicates expansion from existing customers. This provides predictability and visibility into future revenue. Higher is better.

• Customer Retention - Ability to retain existing customers. Higher retention indicates satisfied customers.

• Product Pipeline & Logo/Dollar Pipeline ­- Roadmap of new products to drive future growth. A strong pipeline is usually better.

• Need and Market Opportunity of Product - Size of the addressable market and growth potential. Larger opportunity is generally better.

• Overall Business MOATs & Barriers to Entry - Unique strengths that allow a company to outperform competitors. More sustainable and defensible advantages are ideal.

• Overall Confidence in a Business, Management, etc. - Strength of executives and their strategic vision. Proven and experienced management lowers execution risk.

• Etc.

Ultimately, underlying a revenue multiple are those factors (both quantitative like revenue growth and qualitative like management team), which is why every business isn’t traded at the same revenue multiple. Stated plainly, a dollar of revenue ≠ a dollar of revenue.

These levers have changed frequently over the last five years. Growth was undoubtedly the most impactful single lever for determining the multiple of a company during the 2021 bull market, which led to a boom in low margin, unsustainable businesses trading at outrageous multiples (20-100x+ ARR) and the 5x+ YoY, highly unprofitably software businesses trading in some cases at 100x+ revenue.

Revenue growth is still one of the most impactful inputs for multiples in determining valuation, but it is no longer a standalone metric and used more closely in conjunction with the aforementioned quantitative/qualitative factors. In public markets free cash flow is arguably more important than growth today, though growth still is a huge component as seen via the graph below.

As a trend, revenue growth is highly correlated with a revenue multiple a company still receives, meaning a dollar of fast growing revenue should be worth more than a dollar of slow growing revenue all else equal.  

So what to do with this framework in mind. Well as a GP, when I see a revenue multiple presented either by a company or other GP, I almost immediately mentally discount it entirely and proceed first to try to understand the business to validate whether it is justified (above / below fair market). What should $1 of revenue be worth for this company?

Let’s take two extremes of public companies today – Snowflake & Zoom. Obviously these are not perfectly comparable businesses. Zoom is a video conferencing platform. Snowflake is a cloud-based data warehousing company. But nonetheless they are both high margin, FCF producing late stage software companies valued on a multiple of revenues (as one form).

Zoom is trading at 2.9x annualized revenues and Snowflake is trading at 17x annualized revenues (source Bessemer Cloud). That is a huge difference! This means Zoom would have to generate almost 6x as much revenue as Snowflake to be valued equally to Snowflake.

While both are software businesses with recurring revenues, clearly the market is valuing this revenue much differently… Let’s go through some of the inputs to determine this and to better understand why.

• Revenue Growth: Snowflake at 35.5%; Zoom at 3.6%

• FCF Margins: Snowflake at 24.2%; Zoom at 25.1%

• Gross Margins: Snowflake at 67.6%; Zoom at 76.6%

• Rule of 40 (FCF Margin + Rev. Growth): Snowflake at 75%; Zoom at 30%

• Net Expansion: Snowflake at 142%; Zoom at 109%

• GM Adjusted Payback: Snowflake at 29 months; Zoom at 50 months

• Market Competition: Zoom faces ongoing concern as being perceived more as a commodity and/or may face pricing pressure given Google Meet (can integrate in calendar for free) and Microsoft Teams (bundled product). Alternatively, Snowflake, while facing competition from Amazon Redshift, among others, has key advantages across its architecture, performance and scaling, among other, that make it extremely competitive.

• Switching Costs: Zoom has minimal customer lock as consumers and enterprises can fairly seamlessly move to an alternative like Teams. Alternatively, once customers have invested time and resources into integrating Snowflake into their tech stack, migrating large volumes of data into Snowflake, and training employees on using it, the costs of switching to another provider become quite high. As customers continue storing more data in Snowflake's cloud data warehouse, the "gravity" keeps them locked in compounds over time. Migrating huge data sets is difficult.

• R&D: Snowflake took three years and raised tens of millions in funding just to release its data warehousing product. It is technically incredibly challenging across cloud architecture, query processing, scalability, security, operational excellence, etc. It would go on to raise >$1B before its IPO – there are substantial R&D, IP and other tech barriers to any new entrant. Zoom while also technically challenging is not near that of technical complexity as Snowflake.

• Team: Frank Slootman runs Snowflake – he previously ran ServiceNow, a $100B+ cloud platform, and is generally considered one of the best leaders in enterprise software. Eric Yuan leads Zoom – he previously Vice President of Engineering at Cisco Webex and also considered very highly, but overall arguably not as highly regarded as Frank.

• Market Opportunity: The overall data warehouse market is estimated to be worth around $24 billion currently, and growing at 15-20% annually. Snowflake is disrupting this market by bringing data warehouses to the cloud. Estimates are that it will reach $90B+. Video Conferencing is Zoom's core market. Pre-pandemic the video conferencing market was estimated at around $14 billion annually. With remote work trends it could grow to over $50 billion.

We could go on, but hopefully at this stage, it’s somewhat obvious that a dollar of Revenue from Zoom should not be valued the same as a dollar of Revenue from Snowflake, despite both being fantastic businesses. The reality is Snowflake is growing much faster with large customer expansions, much higher switching costs, a much more competitive relative offering, much higher barriers to entry, overall stronger other KPIs and a much larger need + market opportunity, among other factors.

But overall these are some of the frameworks that are worth thinking through as you try to determine “is this revenue valuable” so that you can determine independently whether the revenue multiples advertised in a memo are over/under fair value. Ultimately the revenue multiple is a reflection of the business with certain factors weighing more than others such as growth, margins, moats, etc., and as compared against the “comps” in the market (e.g. what other company of similar size, stage, and industry has similar KPIs/other quantitative/qualitative factors). Ironically, this post wasn’t meant to be an exercise in valuation, the point is really to help LPs look past the blanket ARR or Revenue multiples seen on deal memo’s and try to dig deeper into discerning independently what is a fair revenue multiple for this business, which I guess is a valuation exercise…

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✍️ Written by Zachary and Alex