At Meritech, we share analyses on trading data, financials, and, perhaps most importantly, valuation multiples across the nearly 100 public SaaS companies we track. As software companies and their boards are asking the important questions “When can I IPO?” and “How big do you need to be to IPO?”, we thought it would be helpful to put the size, performance, and qualitative factors of successful IPOs into perspective. Notably, there is no “size premium” in today’s software market. It’s all about business quality, not the size of the revenue base. The narrative that companies need $1B of ARR (or close to it) is no longer as relevant, and as we look back in history, some of the best-performing SaaS businesses went public between $100-300M of ARR. While the goalposts have shifted over time toward larger companies, other factors such as revenue growth rate and durability of growth, business predictability, operating leverage and margins (i.e. Rule of 40), and a strong platform story are more important than absolute revenue scale. For example, at IPO quarter, Shopify (SHOP) was at $149M of implied ARR, growing 99% YoY, and CrowdStrike (CRWD) was at $313M of reported ARR, growing 121% YoY. Shopify is currently at $8.6B of implied ARR, and CrowdStrike is at $3.4B of reported ARR, worth $90B and $75B, respectively. Fast-growing businesses also don’t stay small for long.
The IPO markets have generally been frozen for SaaS companies since the end of 2021 after there were 50+ IPOs, which was a record year. While the demand (buying) environment for software has softened significantly since 2021, making it more challenging to grow at high rates as companies did during the ZIRP (zero-interest-rate-policy) timeframe, the goalpost expectations on growth and margins have also changed – the market now demands profitable growth vs. growth at all costs. With that being said, the market still values a unit of growth at almost 3x a unit of free cash flow margin. Moreover, there are zero companies in our public index with higher than a 32% year-over-year NTM (next-twelve-months) growth rate expectation. So, if you’re a fast-growing and predictable Rule of 40 company with a credible AI story in a large market, the public markets would likely be highly receptive.
The “Size Premium” Myth
The chart below outputs a few key metrics of public SaaS companies by scale. We release a larger table in a recurring fashion in our Software Pulse. It is clear from this chart that smaller companies are, on average, less attractive on almost every dimension — have lower margins, are less efficient, and, as a result, trade at much lower revenue multiples. The smallest companies (<$400M in implied ARR), have a 54% lower implied ARR multiple than the largest companies (4.6x vs. 10.1x). While the median revenue growth rates of the two sets of companies are the same at ~19% year-over-year, the Rule of 40s, market caps, and revenue scales are quite different. The median market cap is $1.3B for the <$400M implied ARR businesses and $72B for the >$3B+ implied ARR businesses. The smallest companies also have had negative IRRs (internal rate of returns) from the IPO price. Of the 39 companies with <$700M of implied ARR, 27, or 69%, went public in 2020 or 2021 at lofty valuations. As the market pulled back with rising rates, revenue growth slowed and multiples dropped dramatically. As a result, stock price performance has suffered. Many are now “stuck” with slower growth and smaller market caps, making it harder to attract large investors and recruit great talent.
Regardless, great businesses went public in 2020 and 2021 and continue to perform well. The fastest-growing companies have “grown out” of this bucket already, such as Samsara and Snowflake*, which went public with ~$500M of implied ARR and are now at $1.1B and $3.1B, respectively. Hence, they are no longer in the smaller buckets of companies.
Source: CIQ as of 12-Apr-2024 and company filings. Note: Implied ARR defined as quarterly total revenue multiplied by four. Rule of 40 defined as NTM Revenue Growth + NTM free cash flow margin. NTM defined as next-twelve months consensus estimate.
According to this analysis, the larger you are, the better your metrics on essentially every dimension. This is not a surprise for one simple reason: selection bias. Companies with billions of dollars of ARR implicitly have leadership positions in large markets supported by durable growth and strong unit economics that have allowed them to “grow out of” the smaller buckets (and quite quickly). Smaller companies are less valuable due to business quality, not due to scale. If you’re a smaller company and not growing fast, you might get “stuck” in the lower buckets.
Based on the chart above, it might be reasonable to assume that there is a “size premium” for larger SaaS companies. Is that really the case? The short answer is no, not really. The chart below is a regression of revenue multiple vs. ARR scale. There is little correlation between scale and valuation multiple in the public markets: R-squared = 0.11. We’ve removed Adobe and Salesforce from the chart for the sake of visibility, but even when including those, the correlation is still only R-squared = 0.02. That said, the trend line is up and to the right – a symptom of the selection bias mentioned in the prior paragraph.
Source: CIQ as of 12-Apr-2024 and company filings. Note: Implied ARR defined as quarterly total revenue multiplied by four.
Successful Case Studies of “Smaller” SaaS IPOs
For a SaaS company to go public today, there is a narrative that you must be large, i.e. $1B in ARR or close to it. While there may have been a time when that was true over the past 2 years, we do not believe that is the case today. Moreover, there are many examples of companies going public at a smaller scale and going on to create massive, enduring platform companies (like CrowdStrike, Datadog*, HubSpot, Shopify, Snowflake*, and others) and, in doing so, have rewarded shareholders very handsomely. Many went public in a different monetary policy regime, which made it easier to grow faster, but great businesses with fast and predictable top-line revenue growth and strong margins can still be public companies today, even with smaller ARR or revenue scale. While these types of median top-line revenue growth rates (~80% YoY below) are much harder in today’s demand environment given the impact of higher rates (and that companies are pushing more towards efficiency), from a scale perspective, predictable businesses that are $250M+ ARR, growing revenue quickly (30-40% year-over-year) and durably with strong Rule of 40 measures can be exciting IPO candidates. This is magnified for businesses with exciting AI stories.
The output below includes businesses that went public with ~$500M of implied ARR and have since surpassed $1B of implied ARR. All but two of these businesses, Snowflake* and Samsara, went public before 2020. Both have been growing quickly and are above their IPO prices even though they priced their IPOs at elevated multiples compared to historical medians. This group's median MoM (multiple of money) return from IPO price is a staggering 9.1x.
Source: CIQ as of 12-Apr-2024 and company filings. Note: Chart is sorted by implied ARR at IPO quarter. Implied ARR defined as quarterly total revenue multiplied by four. IPO trading metrics represent forward 20-day average from the first time forward estimates were available. Rule of 40 defined as LTM Implied ARR Growth + LTM free cash flow margin. Multiple of money from IPO price. * Indicates current or former Meritech investment.
Comparing Successful “Small” IPOs to Today’s “Small” Public SaaS Companies ($M)
Below, we compare some median metrics from the set of IPOs shown above vs. the current set of public companies in our index that are <$400M of implied ARR. It’s clear these are businesses with very different financial profiles. Again, the valuation multiple ascribed to a business is not about size, but business quality. While a portion of the multiple premia of the listed companies at IPO quarter can be ascribed to a more favorable macro / monetary policy environment (and elevated due to some shares being locked up), we believe that “subscale” businesses that have strong revenue growth and durability, and margins would still command a meaningful premium to the 4.6x median implied ARR multiple that <$400M implied ARR public SaaS companies are valued at today.
Source: CIQ as of 12-Apr-2024 and company filings. Note: Implied ARR defined as quarterly total revenue multiplied by four. IPO trading metrics represent forward 20-day average from the first time forward estimates were available. Rule of 40 defined as LTM Implied ARR Growth + LTM free cash flow margin.
Research Coverage Concerns
A valid risk for smaller companies is the lack of sell-side research coverage, which in turn can cause less interest for your stock, and therefore, the price can fall. Losing research coverage is a valid concern, but it doesn’t only happen because a company is subscale. If you’re a $300M ARR software company growing 75% YoY (and durably) with a strong rule of 40 (which would make you the fastest-growing publicly traded SaaS company), you can expect research analysts will cover your stock and the buyside would likely be excited about owning your stock. Great companies generally don’t have research coverage dropped. Companies can also consider adding more bookrunners to their IPO to expand the potential for research coverage.
Qualitative Factors to Consider for an IPO
Regardless of scale, there are other factors companies should consider. The below is not exhaustive but includes some key questions that companies should ask themselves as they prepare for an IPO in today’s market:
Clear Story
What’s your story? Is it easy to get excited about?
Can you become a multi-product platform? Is the market big enough, or are you making it big through your product offerings?
Are there proof points to support your vision?
Do you have a compelling AI story?
Fast Growth + Some Scale + Strong Efficiency
Be mindful that the public markets want fast (and durable) growth rates, improving margins, and a path to profitability (not just free cash flow positive but GAAP operating profit eventually) i.e.“Can you make money?”
Don’t get “stuck” with slower growth, smaller scale, and mediocre unit economics. This can be a desert
While companies don’t need to be at $1B of ARR or revenue, you should have at least $250M of ARR or $200M in trailing revenue
Are you growing revenue 30-40%+ year-over-year with improving free cash flow margins? Is your growth rate durable?
Are you a Rule of 40 business?
Operational Excellence
You need to have excellent offense (product & engineering, sales, marketing/comms, success) and defense (strategic finance / FP&A, compliance, legal, people)
Predictability = Mission Critical
Can you consistently “beat and raise” on both the top and bottom lines? Around 70% of reported quarters for SaaS companies beat Wall Street guidance
A Reason to Go Public
You need a valid business reason. This can include:
Capital to support growth / expansion or M&A
Validation for enterprise accounts
Coming out party (marketing) for customers / hiring
Liquidity for shareholders
The IPO markets have mostly been frozen since 2021, when a record 112 technology IPOs raised almost $100B. Over 50 of those were SaaS IPOs, the largest amount on record. Since 2022, only a few companies have tried, and only one pureplay SaaS business in Klaviyo went out, which is currently trading below issue price. Rubrik will be trading shortly, too, and both were between ~$650-750M of implied or reported ARR. With that being said, the later-stage private investing market for software is now back to being hyper-competitive, which portends interest from IPO buyers. We believe the best businesses, even at $250M+ of ARR, can be hugely successful in IPOs if they have the attributes of best-in-class businesses with great teams, large markets, fast and predictable growth, strong unit economics, and potential for platform businesses (and with an AI story too, of course!).
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No investment advice. *Meritech Capital is a current or former shareholder in Datadog, Snowflake, and Okta.