Want to get rich?

Email agenda:

Estimated read time: 4 minutes 10 seconds

1. Want to get rich? Start and sell a SaaS - here's why

2. Enterprise value vs equity value (must learn)

3. WeWork pt. 2

Good morning and happy Monday - let's get smarter

Why You Want a SaaS Business

When it comes to the venture capital, private equity, and the general M&A world, there is one business type that rules them all: SaaS (Software as a service)

Why?

Bill Gurley is a venture capitalist who founded the venture capital firm Benchmark

Benchmark is widely regarded as a top VC firm, and the founder Bill Gurley is worth $8 billion

He wrote an article called “All Revenue is Not Created Equal” which highlights what makes certain businesses (and business models like SaaS) worth so much more than others

Here are 3 key reasons SaaS businesses are so valuable:

1. High revenue visibility - most SaaS businesses have subscription revenue / ARR (annual recurring revenue), so the customer pays 1-3 years upfront. This allows the business to have high visibility and predictability of their cash flows. The more visible future cash flows, the more premium valuation the business will get

2. High switching costs - how difficult is it for your customer to switch back and forth between you and your competitor? If it’s hard, you will have more pricing power, customers will stay on longer, and this commands a higher valuation. If it’s easy, the less valuable the business

3. Gross margins - revenue - cost of revenues / cost of goods sold. It’s much harder to generate cash flows with high variable costs / high cost of revenues. 

   1. Walmart has a gross margins of 25% and EBITDA margins (EBITDA as a proxy for cash flows) of 5%.

   2. Salesforce (SaaS model) has gross margins of 73% and EBITDA margins of 12%

If you think about Walmart, for every $ of revenue they make, there is a direct expense of purchasing that good (buying cereal and then selling the cereal)

For Salesforce, there is no physical good associated with each $ of revenue they sell

They can sell multiple customers without their direct costs going up

Now look at the difference in valuation multiples for Walmart and Salesforce below 

Salesforce’s valuation is 50x their EBITDA vs Walmart at 13.8x

This means investors are willing to pay 3.62x for $1 of Salesforce EBITDA vs $1 of Walmart EBITDA

In the picture above, the multiples are a presented on enterprise value

Very few people outside of finance understand enterprise value vs equity value, and it's important

So let me explain

Enterprise value vs Equity Value

In one of our last newsletters, we talked about the company value formula

Company value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate

Equity and enterprise value are the “company value” part

You're probably wondering...why are their two different company values?

Because the companies are worth different amounts to different investors

By different investors I mean there can be equity investors and debt investors

Equity Value

Equity Value: The value of EVERYTHING a company has (Net Assets, or Total Assets –

Total Liabilities), but only to EQUITY INVESTORS (common shareholders)

If you own a public stock - you are an equity investor/common shareholder

A public company’s market cap would be their equity value

Equity value = Market cap = price per share x shares outstanding

Enterprise Value

Enterprise Value: The value of the company’s CORE BUSINESS OPERATIONS (Net

Operating Assets, or Operating Assets – Operating Liabilities), but to ALL INVESTORS

(Equity, Debt, Preferred, and possibly others)

The main issue with equity value (market cap) is it can be changed by a businesses capital structure (how much debt or equity it has) which has nothing to do with the core operations of the business

You wouldn’t want a metric of valuation that can change simply by whether your capitalized with debt funding or equity funding

Enterprise value DOES not change when you change the capital structure since it only looks at operating assets and operating liabilities

Simple Example:

 If you buy a $500K house using a mortgage for 50% of it, the “Equity Value” and “Enterprise Value” look like this

Now if you put 100% downpayment this is what it looks like:

You see just by changing the capital structure and not taking out a mortgage ($0 debt) and all downpayment (equity) you changed the equity value but the enterprise value stayed the same?

That is one of the main reasons, enterprise value (EV) is used as company value instead of equity value

WeWork(ed) You Over Again

Adam Neumann, the founder of WeWork who famously walks around without shoes and was once the darling of VC firms and then lost their biggest investor, SoftBank, $17.7 billion, has started a new real estate business!

Better yet… Andreessen Horowitz (a16z), one of the top VC firms, just wrote him a check for $350m….

So you’re telling me the guy who lost billions of dollars for investors with his previous real estate venture is starting a new one and people are throwing $ at him?

Twitter had a field day with this news

If you have an idea for a real estate startup - I am all ears!! 

- Dev